A few caveats
• These were created by me for me
• I'm a bad typist so these have a ton of typos (keyed using text editor...does things the way I want, not the way Word thinks I want). Scary thing is my typing is marginally more legible than my handwriting
• This is the 5th year in a row I've studied for this exam (but only the 3rd I'll actually sit for it)
• I sometimes use bizzare abbreviations.
• No notes on the case study. Maybe I'll get some, maybe I won't. They are just marginal notes right now.
• If I make any updates between now and exam day, it is because it will help me

Marketing

Pricing

Valuation and Financial Statements

Product Development

Marketing

• special position of public trust - financial well-being & business conduct of insurers is of such importance to so many people
• PO can lose $ if insurers don't adhere to standards
• policies are complex documetns not easily understoon
• PO wants to be treated fairly and ethiclly w/ accurate info

• Background
  • McCarran-Ferguson Act (1945) - state regulates insurance
  • insurance dept - admin agency w/in each state
  • insurance commissioner - head of ins dept
  • NAIC - Promostes coinsistency w/in each state's ins dept
  • insurance laws in two basic categories
    • solvency laws - esnure insurers financially able to meet obligations
    • Mkt Conduct Laws - ensure insurers and distributors operate fairly adn ethically
• Regulation of Products
  • protect customers by requiring certain provisions or not allowing certain provisions
  • require simplified language
• Regulation of pricing
  • reasonbale rate - cover's insurers expenses & provides a fair profit
  • competition usually keeps rates reasonable
  • loss ratios - total claims incurred / total prems rec'd
  • adequate rate - high enough to provide insurer w/ enough $ to pay operating expenses and benefits when they come due
    • life ins rate adequacy indirecly regulated via min reserve reqs
  • equitable rate - prem rate that varies from policy to policy based only on factors affecting the product's costs - not allowed to vary based on race or religion etc
• Regulation of Distribution
  • Licensig of Ins Producters - to get license, must prove: are of good character/meet residency req/pass an exam
    • license for each state/line they sell
    • reciprocity - two states agree that if ok in one state, ok in the other
  • Prohibited Sales Practices
    • Misrepresentation - false or misleading statements
    • Replacement - replacing one contract with another. In itself, not illegal
      • Twisting - misrepresent features of a product to induce replacement
      • Churning - replacing one policy after another to earn series of 1st year commissions
    • Rebating - offer inducement to purchase (not banned in all states)
    • Missappropriation - illegal use of PO funds
    • Commingling of Funds - combining monies belonging to PO(s) w/ producer's own funds
  • Suitability requirement - need reasonable grounds for recommending a specific product as suitable for customer's needs
• Regulation of Promotion
  • Advertising and sales Promotion Materials
    • Advertisement - any material designed to create public interest in life ins/annuities, insurer, producer OR induce public to purchase, increase, modify, restate, borrow on , surrender, replace, retain a policy
    • Insurer ultimately responsible, even if producer creates ad
  • Disclosure
    • NAIC Disclosure Model Reg
      • aid customers in puchasing suitable & reasonably priced ins
      • provide accurate adn reliaebl info to ensure competitive mkt
      • discourage undesirable mkt behavior
    • must give prospect a Buyer's Guide and Policy Summary
    • Buyer's Guide
      • describes various types of ins and points out +/- of each type
      • explains cost comparison indexes
    • Policy Summary
      • disclosure info on specific policy being considered by prospect
• Market Conduct Examinations
  • peridodic exams of insurance co to ensure they comply w/ state laws
  • areas of focus in mkt conduct exam
    • cert of authority adn licensing of agents/brokers nonf options on life ins pols
    • policy form/endorsment approvals sales/advertising materials
    • u/w and rating of policies apps rejected/declined
    • pols cancelled/not renewed replacements
    • claims practices customer complaints

• Antitrust Regulation
  • state antitrust regs, but subject to certain provisions of Fed antitrust laws
  • Boycott - competing cos agree to refrain from doing business w/ another co
  • Coersion and Intimidation - methods of force used by a business to make another business act or refrain from acting in a certain manner
  • Price fixing - competing businesses act together to affect the price of a product
• Consumer Protection Regulation - affect mktg of life and health ins
  • FTC Act - regulates unfair competition, deceptive business practices adn prohibits false or deceptive advertising that crosses state lines
  • Fair Credit Reporting Act (FCRA) - must comply when insurer obtains credit reports for u/w or claims investigation
  • GLB Act Privacy Provision - protect non-public personal info from indescriminate dessemination.
    • disclosure of practices @ beg of relationship and annually thereafter
    • allow opt-out of sharing
    • maintain policies to protect security and confidentiality of non-public info
    • refrain from sharing acct #s w/ non-afiiliated 3rd parties for mktg purposes
  • HIPAA 1996 - privacy protections for group adn health mkt
  • Regulation of Variable Ins Products
    • subject to regulation by SEC
    • 4 fed Laws affect mktg of variable products
      • Securities Act of 1933
      • Securities Exchange Act of 1934
      • Investment Co Act of 1940
      • Investment Advisors Act of 1940
    • Securities Act of 1933 - Truth in Securities Act
      • general fraud provision - prohibits misrep
      • registration provision - must provide essential info
      • prospectus - most of the info in the registration statement
        • any communication (written or oral) that offers security for sale
    • Securities Exchange Act of 1934 - gave SEC broad authority to regulate securities
      • primary focus - registration of brokers and dealers who sell securities
      • securities broker - indiv, corp or other legal entity engaged in business of buying/selling securities for the account of others
      • securities dealer - engaged in business of buying/selling securities for own account
      • firms that sell must a) register as B-D w/ SEC and b) become member of NASD
      • NASD - non-profit self regulating org responsible for making sure everyone follows rules
      • SEC registration of B-D - most often an insurer will create and register a subsidiary ot be a registered B-D
      • NASD Registration of Respresntatives and Principals
        • Registered Rep
          • business assoc of NASD member
          • engages in securities business on behalf of member
          • passed a specified NASD exam
        • Principal
          • officer/manager or an NASD member
          • involved in day-to-day operations of securities business
          • qualified as a registered rep
          • passed additional exams
      • NASD regulatory Oversight Activities
        • B-D must supervise reg reps & principals to ensure compliance
        • reg reps and principals must serve customers properly and deal fairly w/ public
        • reg reps mush have reasonable grounds for believing recommendation is suitable
        • NASD approval of ads and sales lit
          • Name of B-D
          • no promises of results exaggerations or opinions w/ no reasonable basis
          • don't imply state or fed endorsement/approval of product
          • no rediction/project o finvestmetn results
      • SEC "Good" Internal Controls
        • strong/capable compliance/legal staff
        • create regular exceptino reports and review
        • regular communication w/ customer - disclose fees/risks
        • periodic reviews of customer holding by branch office
        • written procedures fro branch audits w/ written reports as results
        • clear compliance guidance to producers
        • regular provider trainig - compliance/security laws/self reg rules
        • immediate discipline
        • review producers to ensure continued licensing/education req
        • optical scanning instead of manual paper-based processing
        • written procedure to minimize error/delays
        • quality control unit to monitor trx processing
        • procedures to separate adn secure incoming premium payments
    • Investment Company Act of 1940 - regulates conduct of investment cos
      • Sep Acct considered an investment company by act
    • Investment Advisors Act of 1940 - conduct of investment advisors
      • investment advisors - compensated for providing advince to investors about value of securities or advisability of buying/selling securities
      • if producer sells VA/VUL and only gets commissions, not req'd to register as investment advisor, jsut reg rep or principal
  • Federal Regulation of Bank Insurance
    • Licensing and Locatoin
      • agency/B-D must be clearly identified adn separate from teller area
      • employee must be properly licensed/registered
      • must fully and accurately disclose identity of business providing the service
    • Prohibited Sales Practices
      • Tying Arrangement - conditions the sale of one item on the sale of another
    • Advertising adn Dsiclosure Requirements
      • Fed Banking laws require additional disclosures
        • product is insurance/annuity and not bank-guar product
        • amounts payable are premiums and not deposits
        • product is not insured by FDIC or other gov't agency or bank

• Background
  • Dual regulation - both federal and provincial govt regulate
  • Federal - OSFI
• Provincial Regulation of Market Conduct
  • Insurance Act of each procince regulates conduct and creates Office of Superintendent of Ins
  • Canadian Council of Ins Regulators (CCIR) - similar to NAIC
    • because of CCIR - fairly uniform regs across provinces
  • CLHIA (Canadian Life and Health Ins Association)
    • voluntary associate that promotes self-regulation to avoid over-regulation
    • CLHIA guidelines
  • Products
    • CCIR Uniform Life Ins Act & Uniform Acc and Sickness Ins Act - adopted by all provinces by Quebec
    • CLHIA Indiv Var ins Contracts (IVIC) Guidelines
      • Compliance Report - questions exploring compliance
      • Information Folder - collection of 21 items to prove financial soundess of a product
    • Policy Form filing required if
      • condition to obtaining license to conduct business w/in province
      • before mktg an individual variable life contract
      • no new filings for trad products after licensed
  • Pricing
    • indirectly since ins must charge adequate rates to fund sufficient assets
    • prohibit unfair discrimination (race/sex/religion/etc)
    • can't discriminate between two people who present same risk
  • Distribution
    • Producer Licensing - no special license to sell variable products but must be accredited by provincial securities commission
    • Prohibited Sales Practices - similar to US
      • in addition, license revoked if
        • violates ins act and/or related regs
        • material misrep on license app
        • guilty of fraudulent practice
        • demonstrates incompetence or untrustworthiness in trx of life ins
  • Promotion - prohibits specified ad/sales promotion practices adn mandates cost/benefit disclosures
    • Advertising and Sales Promotion - prohibits
      • false/misleading ads or statement re: policy features
      • conduct that results in unreasonable delay/resistance to fair settlement of claims
    • Add'l guidance by CLHIA prohibits
      • false/misleading statement/presentations/testimonials
      • disparaging statements about other insurers or their products
      • statements w/ tech/industry language beyond general public understanding
      • guarantees unless conditions/limitations fully explained
      • Coupon Advertisements
        • must be truthful and not misleading
        • must define terms & disclose exceptions/exclusions/limitations
  • Cost adn Benfit Disclosure
    • CLHIA-developed buyer's guide
    • policy summary
    • if guarnateed values of reatures mentions, must be display inillustrations
    • if non-guar elements displayed, illustration must have at least two summaries
    • variable products - must give copy of Info folder onfile w/ office of super
      • describes guar/non-guar benefits
        • method of determing benefits
        • surr/loan/nonf provisions
        • charges imposed if surrendered
• Federal Regulation to Maintain Competition
  • Ins Co Act - Admin by OSFI - regulates
    • fed incorp ins cos
    • insurers incorp outside of Canada but do business in Canada
    • provincially incorp insurers that choose to register w/ fed gov't
    • regulates incorporation, corp governance, solvency
  • Competition Act (1986)
    • Prohibits
      • mergers/monopolies that may operate to detriment of public interest
      • price fixing agreements that unduly lessen competition
      • other anti-competitive or deceptive mktg or unfair trade practices
• Feds - Privacy
• Provinces - Customer Protection

• Planning
  • - Set Marketing objectives
  • - establish guidelines for implementation and control of mktg activities
• Organizing
  • - establish a framework for carrying out mktg plans
• Implementation
  • - Execute mktg plans
• Control
  • - analyze results
  • - evaluate performance
  • - make necessary changes

• +Corporate Planning
  • primarily strategic
  • consists of establishing company's overall business plan
  • top-down. begins by deining the company's mission - defines scope of org's business activities and business direction
  • Establishs Corp objectives - long term results co hopes to achieve
  • Outlines Coprorate Strategies - long term methods used to achieve objectives
  • must regularly evaluate plans to make sure still appropriate
• +Marketing Planning
  • bottom up portion of planning process

• 1-5 years into the future. review and update as necessary. as oftern as every 6 months. focus on long term
• - establishes marketplace objectives
• - defines the target market
• - develops mktplace stategies
• - defines resource needs

• 1-2 years into the future - focus on the day-to-day
• - develops action-oreineted product, price, distribution and promotion tactics
• - describes when activities will take place, how they will be performed and who will perform them

• 3 primary activities: analyze situation, establish objectives, develop course of action
• Conducting a Situation Analysis
  • 3 primary parts: environmental analysis, environmental forcast, internal assessment
  • Environmental Analysis - ongoing exam of outside events/relationships that can influence strategic decion making
    • Key environmental areas for Financial Services Corp (fig 5-3 p 105)
      • - current target markets
      • - competition
      • - economy
      • - society
      • - technology
      • - regulation
      • - labor
      • - distributors
      • - international conditions
  • Environmental Forcast - prediction of major environmental trends that will affect a companies business activities
    • several types of forcasts available from businesses, universities, governments and industry associations
    • commercial forcasts are a good starting point
  • Internal Assessment - exam of co's current activities, strenghts, weekenesses and ability to respond to potential threats & opportunities in environment
    • internal factors that have greatest effect on co's mktg planning:
      • - mission
      • - fin, tech, human resources
      • - current distribution systems
      • - product lines
      • - operational efficiency
• Tools of Analysis
  • SWOT Analysis
    • Strengths, Weaknesses, Opportunities and Threats
    • Mktg Opportunity arises when right combo of circumstances allows co to use its strenghts to take advantage
    • Strategic Window - time period where optimum fit between co's distinct capabilities and key requirements of mktg opportunity
  • Business Portfolio Analysis
    • allows co to evaluate business units according ot their potential contribution to co
    • determines units potential for:
      • - generating financial resources
      • - requiring financial resources
    • SBU - strategic business unit
      • - operated as a separate profit center
      • - own seperate set/share of customers adn competitors
      • - own mgmt (generally)
      • - owm mktg strategy
    • Marketshare/Mkt Growth matrix - Boston Consulting Group
      • - Star - high mkt share, high growth mkt - becomes a cash cow when mkt growth slows
      • - Cash Cow - high mkt share, low growth mkt
        • primary role - provide income to cover corp overhead, pay divs, finance R&D
      • - Question Mark (aka Problem Child) - low mkt share, hight growth mkt
        • requires more cash than they generate
      • - Dog - low mkt share, low growth mkt
        • generate enough revenue to cover their own expenses
        • unlikely to become stars or cash cows
      • many SBUs have the following life cycle
        • Question Mark -> Star -> Cash Cow -> Dog -> sold/discontinued
    • Market Attractiveness/Business Strength Matrix - GE and McKinsey & Co
      • created to address problems w/ mktshare/mkt growth matrix
      • 9 matrix cells
      • business strength - strong/average/weak (x-axis)
      • mkt attractiveness - high/medium/low (y-axis)
      • "A" - good investment/growth opportunity
      • "B" - average opportunities
      • "C" - little growth/investment potential
        • high A A B
          • med A B C
          • low B C C
            • strg avg weak
      • mkt attractivness - composite index - uncontrollable env factors
        • - market size - market growth rate
        • - gov't regulation - mkt stability
        • - competitive intensity - tech reqmnts
      • business strength - composite index - controllable factors
        • - price competitivness - product quality
        • - customer loyalty - mktg skills
        • - sales growth rate - relative cost advantages
        • - tech and fin resources

• objectives s/b
  • - clearly stated
  • - specific and measurable
  • - realistic
  • - actionable
• objective shoudl specify (in quantifiable terms) what is to be accomplished and time period to accomplish it
• Corp Objectives - normally 1-5 years
• Marketing Objectives
  • primary - describe overall mkt response they hope to achieve in target mkt
  • secondary - cover mktg functionnnnnnns needed to carry out plan

• Corporate Strategies
  • - intensive growth strategy - usually requires significant financial resource
    • + Market Penetration - increasing sales of current products to current mkts
    • + Mkt Development - increasing sales of current products to new mkts
    • + Product Development - increasing sales of new/modified products to current mkts
  • - diversified growth strategy - venture beyond normal business domains
    • + Horizontal Diversification - intro diff products to co's current mkt
    • + Concentric Diversification - new mkts, new products similar to current products or current mktg methods
    • + Conglomerate Diversification - new mkts, new products that bear no relationship to curernt products
      • same product related new product unrelated new product
    • new mkt mkt development concentric diversification conglomerate diversification
    • same mkt mkt penetration product development horizontal diversification
  • - Integrated Growth Strategy - taking over another level of industry or dist channel
    • + Forward Integration - control of distribution channel
    • + Backward Integration - upstream (manufacturer or supplier)
    • + Horizontal - competitor
• Marketing Strategies
  • focus w/r to SBU's mkt share
  • + Build Strategy - increase mkt share. usually S/T loss (capital outlay) for L/T gain
    • most appropriate w/ relatively low mktshare in relatively high growth rate mkts
    • Question Marks or "A"s
  • + Hold Strategy - maintain mkt share
    • Cash Cows or "B"s
    • appropriate for high mkt shares in low growth mkts
  • + Harvest Strategy - maximize S/T earnings and cash flow
    • appropriate for weak growth potential
    • weak Cash Cows, Qeustion Marks, Dogs adn "C"s
  • + Withdrawal Strategy - selling/discontinuing a SBU
    • appropriate for weakest growth and inv potential
• Tactical/Action Programs
  • - what activites are to be performed
  • - how/when/where they are to be performed
  • - who is responsible for performing each activity
  • - how much each activity will cost
  • - type and magnitude of results expected from each activity
  • - main elements of uncertainty involved
  • - how results will be monitored and evaluated
  • Benchmarking - identify best practices adn outcomes
    • - emulate best practices to equal/surpass best outcomes
    • avoids reinventing the wheel
  • programs must be coordinated and integrated to be successful
  • formed for each marketing area and combined to form annual mktg plan
• Setting Budgets
  • tell Sr Mgmt how much and when - bottom up
  • sometimes top down and funds need to be allocated. Proposed programs scaled up/down as necessary
  • budgets provide feasibility info

• written document that specifies marketing goals for a product/product line and describes strategies and implementation and control efforts co intend to use to achieve those goals
• focuses on target markets and elements of marketing mix
• Benefits
  • - facilitates communications among all levels of org and among function units
  • - allows mgmt to monitor consistency of actions across units
  • - focuses EE on right issues
  • - keeps poeple focused on overall goals
  • - provides basis of performance comparison
• Elements
  • - executive summary
  • - situation analysis
  • - mktg objectives
  • - mktg strategies
  • - tactical/action programs
  • - budgets
  • - control mechanisms

• Essential Mktg Functions
  • - Information Management
  • - Marketing research
  • - product development and pricing
  • - sales and distribution
  • - advertising, sales promotion and publicity (aka Mktg Communications)
  • - customer relations
  • - mktg personnel development
  • - mktg mgmt and admin
• Four common mktg structures: function/product/geog region/customer type
• Organization by Function
  • most common
  • different areas of responsibility depending on work performed
  • ex. Chief Mktg Officer/Mkt Research Mgr/Sales Mgr/etc
  • Advantages
    • - simplicity
    • - focuses on developemnt of managerial and tech skills
  • works best w/ small cos or cos w/ homogenous customers
• Organization by Product
  • each SBU responsible for its mktg (most of)
  • may be some shared services
• Organization by Geographic Region
  • usually mktg manager for each region
  • usually some shared services
• Organization by Customer Type
  • mktg manager for each division
  • ex: households/small business/big business
• Combination Structures
  • flexible - meets both co's strategic implementation needs and customer needs
  • Matrix Organizational Structure
    • project manager directs individuals from different function areas
    • two bosses during project

• Mktg Implementation - process of translating mktg plans and strategies into action
• accomplished through day-to-day tactical and operational activities

• marketing control - process of examing results of mktg plans and company to plan and taking actoin to keep it on track

• performance std - internal vs external std
  • - usually incorporated into mktg plan
• management by exception - mgmt only gets involved if performance outside acceptable range
  • - saves time and allows attention to be focused on problems/opportunities
• if a problem, read to identify toe cause and take actions to correct
  • - change tactical/action programs
  • - establish new implementation method
  • - new strategies
  • - modify how performance data collected/analyzed
  • - re-evaluate performance standards
• control tools
  • sales analysis vs
    • - forcasted sales - prior years sales
    • - expenses to generate sales - competitors' sales
    • - estimated mkt potential - current industry sales
  • measured - # products, 1st yr comm, face ,avg prem, etc
  • expense analysis
    • natuaral accounts - ledger accounts
    • functional accounts - based on purpose
    • expense ratios - ex. mktg expenses/$1m face sold
  • profitability analysis
    • compares sales to expense incurred to generate sales
    • use several years data since for line ins, 1st yr expenses > 1st yr revenues
    • valuable source of info since combines sales and expense info
  • mktg audit
    • systematic examination and appraisal of mktg environment, objectives, startegies, tactical/action prgms, organiztional structure and personnel
    • key areas of mktg audit (chart p 135)
      • mktg environment
        • macro environment
        • task environment
          • mkts adn customers
          • other factors in mktg system
      • mktg strategy
        • business mission and mktg objectives
        • mktg strategy
        • budgets
      • mktg organization
        • formal structure
        • functional efficiency
        • cross-functional efficiency
      • mktg systems audit
        • mktg info system
        • mktg planning system
        • mktg control system
        • new product developemnt
      • mktg productivity audit
        • profitability analysis
        • cost-effeciveness analysis
      • mktg function audit
        • products
        • price
        • distribution
        • promotion
  • Reporting Sytems
    • - provide managers w/ detailed summary info as needed
    • - provide accurate adn timely info
    • - be flexible to adjust to co's changing info needs
    • - be cost effective
    • - easily understood by
      • + those who evaluate performance
      • + those whose performance is being measured
    • detail s/b appropriate for level
      • lower level needs more detail
      • higher level mgmt needs just summary

• dividing large markets into smaller markets w/ similar product/mktg mix needs
• single variable segmentation - only 1 variable to segment market
• multiVariable segmentation - uses combo of variables
• Requirements for Effective Segmentation
  • - customers should have similar product needs/buying habits
  • - needs/behaviours s/b distinguishable from other segments
  • - potential sales/costs/profits s/b lare enough to be measured and compared to other segments
  • - profit potential enough to warrant segment attention
  • - customers accessible thorugh currently available means
  • - size/composition s/b relatively stable over planning period
• Bases for Segmenting Consumer Markets
  • Geographic Segmentation
    • country/region/state/county/zip/legal boundaries/rural-suburuban/urban
  • Demographic Segmentation
    • age/sex.marital.household composition/income/education/occupation/family life cycle/nationality/race/etchic group/social class
  • GeoDemographic Segmentation - combo of geographic adn demographic
    • economic means/cultural background/perspective/neighborhood
  • Psychographic Segmentation
    • lifestyle/activities/interests/opinions
  • Behavioristic Segmentation
    • benefits sought/usage rate/buyer readiness/pref method of purchase/risk tolerance/buyer loyalty
  • Demographic - commoonly used in consumer markets
    • traditional life ins demographics - hi/middle/low-income households and families/boomers/seniors
• Bases for Segmenting Organizational Markets
  • Organizational Mkts - group benefits and continuation of business operations
    • therefore two markets, group and business
  • Georgraphic Segmentation - simialr to consumar markets
  • Demographic Charachteristics
    • business activity/type of group-organizatoin/size of group-organization
    • SIC - Std Industrial Classification - 1930
    • NAICS - N. American Industry Classificatino System - by-product of NAFTA
    • small groups <=100 - 80% of contracts, 25% or prem
    • medium groups 101-499 - 10% of contracts, 25% of premiums
    • large groups 500+ - 10% of contract, 50% of prem
  • Behavioristic Segmentation
    • similar to consumer markets - usage is a key

• process to identify, select and focus mktg efforts
• Evaluating Potential Target Markets
  • Mkt Size and Growth Potential
    • majority fallacy - blind pursuit of largest, most easily identified or most accessible mkt segment
    • competition makes big mkts less profitable
    • should offer combo size/growth/profitability that best meets co's needs
  • Mkt Attractiveness
    • depends on level of compettition and buying power of consumers
  • Company Goals and Resources
    • only puruse targets if it has (can easily get) fin/tech/hr necessary to compete sucessfully
• Target Mktg Strategies
  • Undifferentiate Mktg - mass mktg - singel mktg mix for entire mkt
    • + cheaper since only one mkt strategy
    • - might miss differences w/in segment
    • - disadvantage to specialty marketers
  • Concentrated Mktg
    • for a product - focus all mktg efforts on a single segment of total mkt
    • Niche Mktg - form of concentrated mktg w/ narrowly defined mkt
    • - all eggs in one basket
    • + can be profitable
  • Differntiated Mktg
    • offer differing product/mktg mixes to appeal to diff segments
    • - most expensive
    • + better served customers = incr customer satisfaction = incr sales
  • Factors to consider when picking mktg strategy
    • company resources - if limited, concentrated probably best strategy
    • product variability - homogenous products - undifferentiated mktg
    • Mkt Variability - if buyers have similar usage/purchase patterns - undifferentiated
    • product's life cycle stage - new products - concentrated/undiffernetiated
      • - mature -differentiated
• Consumer and Organizational Target Markets for Ins Products
  • Affluent Consumers
    • mass affluent - 100k -$1mil liquid assets - 99.9% of affluent mkt, 54% of total mkt assets
    • high-net-worth - $1-25 mil liquid assets - 0.1% of mkt, 31.3% of assets
    • ultra-high-net-worth - 0.001%, 15.1% of total mkt assets
  • Single-Parent Families - need large amt ins to protect single wage earner
  • Non-family Households - low need for life ins, high need for health/retirement products
  • Working Women - strong potential for wide range of products
  • Employer Groups - ex. negotiate trusteeship/voluntary trade assoc/MEWA
  • Small Businesses - rapidly growing segment - approx 99% of businesses are small businesses
    • significant market for products that
      • - protect against loss due to death/dis of owner
      • - preserve value/prevent liquidation due to owner/partner death
      • - preserve sharelohlder equity/mgmt control due to majority shareholder death
      • - protect against death tax on inherited business
      • - enhance credit/fin stability by assuring business continuation
      • - source of emergency funds
      • - non-qual def comp to attract/retain key employees
      • - EE health/life/dis ins and qual ret plans

• Distribution Channel - network of cos and people that performall mktg activities req'd to deliver products to customers
• 3 types: personal selling/financial institutions/direct response

• Agnecy-Building Distribution Systems
  • Ordinary agency distirbution system - full or part-time agents to sell/service ins pols
    • field force - agents in the system
    • career agent - full-time commissioned salesperson w/ agency contract
    • agency contract - agreement that defines roles/responsibilities/compensation/power of agency
    • power of agency - agents right to act for the insurer
    • Career Agents - independent agents, not employees
      • exclusive agent - tied/captive - not permitted to sell other insurers products
      • agent-broker - broker - places business w/ cos other than primary co
    • marketing territory - geographic area insurer distributes products
    • field offices - sales offices in marketing territory
      • considered a branch office or agency office
  • Branch Office System
    • Branch manager responsible for increaing sales/recruiting and developing career agents/managing expenses for the co
    • Branch manager and office staff are ins co employees
    • Agent in branch office under contract to ins co, not branch manager
  • General Agency System
    • Agency offices established, maintained and funded by general agents
    • General Agent - Independent agent under contract to insurer
      • primary funtion of GA is to build and manage an agency of career agents focused on distributing products of single insurer w/in defined territory
      • GA is agent of insured, not EE
      • office staff EE of GA, not insurer
  • Comparison of Branch Office adn General Agency Systems
    • expensive to build field force from scratch so use GA system
    • GA bears some/all of agency startup costs incl office expenses/salaries
    • Insurer commission costs ~ sales
    • Branch office - high costs @ beginning even though sales low
    • Well established insurers prefer branch office
      • - greater control & flexibiltiy
      • - can transfer personnel between territory
      • - can transfer someone w/ experience vs training from scratch
      • - rewards good producers w/ better territories
    • under GA, need consent of GA to transfer people
    • distinction between GA and Branch office getting fuzzier
• Multiple-Line Agency (MLA) Distribution System
  • uses career agents to distribute life/health/p/c ins for group of commonly managed or financially related ins cos
  • MLAs establish own office w/ little/no help from insurer
  • benefits of MLA system
    • - efficiency in serving certain markets - one agent for all needs
    • - opportunities to cross-sell products
    • - persistency - more business and more satisfied = better persistency
    • - economies of scale for insurer
• Home Service Distribution system
  • exlusive agaents (home service agents/debit agents)
    • defined products/defined territory
    • autohorized ot collect renewals @ PO's home
    • employees of home service co
    • req'd to keep certain hours and may be transferred
  • MDO policy (monthly debit ordinary) - prems collected monthly at PO's home
    • 1k-25k face amts typically
  • PNO policy (premium notice ordinary)
    • $10k/$15k min face
    • prems paid via mail/payroll ded/mbd/eft but may be collected at PO's home
  • usually a district office w/ district manager
  • districts split into territorys - 1 agent/territory
• Worksite Mktg Distribution System
  • individual/grp ins distributed at place of work on voluntary, paryroll deduction basis
  • advantages
    • - effective way to reach and meet the needs of mill/lower income mkts
    • - more cost effective than distribution of indiv plans of ins
    • - builds name recognition
    • - possible gateway to sell grp benefit products to employer
    • - payroll ded less likely to lapse that direct billed for EE who remain w/ company
  • disadvantages
    • - two sales to make - one to employer, one to EE
    • - small face amounts and prems
    • - persistency problems in high turnover workplaces
• Location-Selling Distribution System
  • consumer initiated sales at kiosk/desk in other store
  • may be agency building or direct response dpeending on staffing levels
  • pre-need funeral is a specialized type of location-selling
• Salaried Sales Distribution System
  • relys on salaried sales reps to sell/service products
  • employees of insurer and paid salary
  • Group Representative - handle group sales - specially trained for groups
  • Call and Contact Centers
    • call center - phonebank for support
    • contact center - like phone center but email/mail/phone/web chat
    • possible source of cross sells
• Non-Agency-Building Distribution Systems
  • Pros
    • - don't have to train/finance or provde office support
    • - less expensive to establish
    • - expenses linked directly to sales
  • Cons
    • - agents not exclusive
    • - less control
  • Brokerage Distribution System
    • uses agent-brokers and licensed brokers
    • licensed broker
      • - independent life broker
      • - licensed to sell but not under an agency contract w/ any insurer
      • - responsible for own office space and other expenses
    • producer group
      • - independent producers organized
      • - negotiates compensation/product/service arrangements w/ ins co
      • - normally focus on specific segment of mkt
    • soliciting brokerage business
      • Brokerage Rep
        • appointed to solicit brokerage business and appoint brokers on behalf of co
        • may be full-time salaried employee or soliciting agents
      • Brokerage General Agency
        • agency operated by Brokerage General Agent (BGA)
        • BGA - independent agent under contract w/ numerous insurers
        • BGAs have minimum production reqmts
        • primary function - encourage agents/brokers to sell products of cos BGA represents
      • Wholesaler - broker rep that solicits business for an insu co primarily from broker-dealers adn banks
  • Personal-Producing General Agency (PPGA) System
    • PPGA - commissioned salesperson, not housed in insurer's field office, engaged primarily in personal production
    • most co's that licensse PPGAs have min prod reqs
    • soliciting PPGA business
      • Regional Officer - independt contractor or EE who recruits and manages PPGAs for only one insurer
      • Managing General Agent (MGA) - indepentd contractor typically recruits and manages PPGAs for # diff cos
    • primary advantange of PPGA system - tendency to hold down costs
  • Professional Advisors Distribution System
    • Financial planners/CPAs/Attorney distributing life ins
    • sometimes fee based, sometime commissioned
    • laws and ethics codes are strict for these folks - lots of extra disclosures

• Broker-Dealer (B-D) Distribution System
  • variable products can only be distributed through B-D
  • if insurer want to distribute variable products
    • register ins co as B-D
    • establish sub that registers as a B-D
    • mkt prducts through affiliate that is a registerd B-D
• Bank Insurance
  • distribution of ins to bank customers through bank-affiliated insurer or ins agency
  • authorized by Gramm-Leach-Bliley Act (GLB Act)
• Insurance Companies
  • nonproprietary products - products manufactured by another insurer
  • common products - DI/Indiv Health/small group health
  • done to keep agents/customers happy
  • home-office-to-home-office arrangement
    • HO distributes specific product lines mfg by another insurer
  • career agents allowed to broker on their own for products not carried
  • in-house brokerage agency - solicits dist agreements w/ other cos for prodcuts not offered
    • keeps exclusive agents from dealing with other cos

• overview
  • normally noface-to-face contact occurs - sometimes phone sales reps or agents
  • Direct Response Mkts - using one or more media to elicit an immediate and measurable response from a customer
  • Two types of direct response materials
    • Invitation to inquire - communications designed to generate interest in product/service and provide prospects w/ means to request and receive add'l info
    • Invitation to Contract - communicaton desited to solicit and close a sale
  • fullfillment kit - package of materials designed to address customer's request
• Products Distributed Through Direct Response Marketing
  • generally simple to apply and pay for, u/w, administer
  • typically non-med or guar iss basis
  • non-med basis - sold w/o exam by doc/paramed - may have health questions on app
  • guar-iss basis - no indiv u/w takes place - if an eligible member of group, apply and meets specified contitions, automatically issued a policy
• Media used in Direct Response Marketing
  • Direct Mail - generally print form via mail service - contains mail kit
    • mail kit
      • intro letter response device (application/form)
      • brochures business reply envelope
  • Telemarketing - use telephone to produce sale
    • Outbound Telemarketing - co calls you
    • Inbound Telemarketing - cust call your - usually as a response for other ads
  • Internet
    • Aggregator - site where users can comparison shop many co's for rates
  • Type of Mailing Lists
    • House List - compiled from people who have shown interst in co or been referred by current customers - most productive list
    • Response List - people who have brough from another co through direct response - their house list - second most productive list
    • Compiled List - derived from direcories/newspapers/tradeshow registrations/ etc

• Actuary responsible for product designs and pricing is as much a part of mktg as those more directly involved
• product design adn pricing should not be done in actuarial vacuum, but integral part of total mkt strategy
• must be familiar w/ mkt segment targeted & dist-system used in order to properly price products

• Critical Ins Co functions
  • establishing mkt objectives
  • determing how to grow in mktplace
  • implementing strategies to implent these goals
• mktg objectives s/b designed to maintain existing business and generate NB w/in existing mkts adn from existing dist channels
• growth objectives s/b designed to generate NB from new mkts, new products and new dist channels
• mkt adn growth objectives s/b based on
  • historical results - where co has been, is today, and why
  • strengths - s/b viewed as opportunities and capitalized as either competitive edge or way to enhance profitability
  • weaknesses - eliminated or minimized as much as possible
  • external environment - assesment includes
    • competition
    • consumer needs/desires
    • demographics
    • economic conditions
    • int rates
    • inflation
    • reg climate
    • consumer attitudes
    • gov't intentions (regarding public/private fin security issues)
  • internal assumptions
    • assume sufficient CF & reserves to support sales goals and forays into new mkts, products, dist channels
    • strategic assumptions about how it will utilize capital and other resources
• mktg strategies
  • specific interrelated & complementary activities a co will perform to achieve its goals
  • markets, product, distribution

• specific mkts co wants to operate in
• must be indentified and defined as precisely as possible
• definition includes
  • demographic characteristics
  • geographic location
  • lifestyles
  • motivation
  • needs
  • product use
  • social mobility
• each mkt mustbe measurable (size and purchasing power)
• must be large enough to be profitable and reachable by distribution
• once mkts identified, can plan how to best penetrate these mkts
  • req'd resources, who will implement, time frame

• products offered must be suitable to targeted mkts and dist systems
• must be designed to support mktg adn pricing objectives
• objectives for quality, services and growth s/b met w/in budget adn w/in expense loadign for each product line

• Cos must tailor each dist system to mkt it will serve and products it will sell
• pay attention to what is needed to enhance capability of field & HO to deal w/ new products and to penetrate targeted mkts
• pay attention to how internal programs might impact dist system

• offer assistance to mktg officer in formulation of mktg mgmt objectives and strategies
• gauge potential effects of mgmt decisions
• project expectd results
• take active role in design of product and compensation
• measure progress toward attainment fo mktg objectives
• advise on impact of strategies on fin rating
• advise on appropriateness of sales illustration

• conducting surveys to analyse
  • sales and persistency trends
  • census demographics and econ stats to sales data to id mkt-potential
  • developing conservation programs
  • studying profiles of buyers and products purchases
  • examining trends in buying and paying behavior
  • exploring motivations invovled in various purchases
• conducted both at company and industry level
• study both internal ins environment and external environment
• external environ - demographic,economic, regulatory, cultural, technical trends that may affect ins mkts
  • sources: fed govt agencies, private industry, trade orgs, professional assoc & vendors
• conducted at industry leve by various ins fin services trade orgs and prof ins orgs
• helps senior management in
  • setting company objectives
  • monitoring goals established by such objectives

• montior sales activites and their persistency
• tracked by several measures including product lines and dist systems
• results are used
  • strategic planning process
  • establish mkt share goals adn monitor such goals
  • as performance criteria
  • competitive intelligence process
  • diagnose strengths adn weknesses
  • mkt segmentation purposes
  • motivational purposes
  • measure of the mktg effectiveness of the ins industry
  • problem identification

• Individual Life
  • qtrly and ytd indiv life sales performance trends by dist channel
  • annualized new premium, face amt, # pols, avg size pol, prems/pol, prem/$1m
  • allows cos to compare results w/ others
  • WL/Term/UL/VUL
• Individual Annuities
  • qtrly sales trends by product type
  • deposits for variabel adn fixes annuites, qual/nonqual, single prem/periodic prem
• Individual Health
  • DI - qtrly indiv DI sales by annlzd prem and # pols
  • LTC - new issues and trends in inforce
  • Indiv Health - annlzd prem & pols - medicare supplement, acc, hospitalization, major med, comprehensive
• Buyer Study
  • Indiv life sales observed for trends in variety of product and buyer characteristics
  • provides overall picture of industry
  • hleps w/ design of new products

• helpful to have info on competition w/ mkt share
• analyse using primary (internal company) data along w/ secondary data
  • used to estimate expected growth rates
• sources fo seconday data:
  • US Census Bureau - population and household counts, estimates and projections by area
  • Bureau of Economic Analysis - aggregate personal and per capita income for areas & income proj
  • Bureau of labor Stats - unemployment stats adn workforce size
  • Nat'l Assoc Realtors - housing starts and sales and home values
• Persistency Studies
  • periodic studies for indiv def ann, indiv life, indiv DI
• Consumer adn Field Force Surveys
  • mostly mktg info from
    • analysis of internal operating stats
    • policyholder records
    • trade assoc figures compiled across groups of cos
  • more and more info from own records
  • move from policy records to client records (householding)
  • focus groups can help w/ consumer info
  • industry studies needed for avg ins holding and similar data
• Public in General
  • ACLI surveys American Public
• Sub-Population of the General Public
  • survey of widows/people who recently bought through a bank/etc
  • survey ow policyowners
    • cross section or subgroup such as recently serviced or recently terminated
• Field Force
  • evaluating compensation systems, portfolio, policyowner service, field-HO communication, quality of agent training
  • wants & needs of public - at least agents perception
  • field survey vs field advisory council
    • field survey represents all agents, not just most vocal/top producers
    • field morale improved if ask all
• Caveats
  • surveys can mislead - using info for purpose other than intended
  • surveys are an "art" and trick to get set up adn utilized properly

• two distinct dist systems in US: Agency and Direct Response

• Career Agents - co recruits, finances, trains & sometimes houses agents to represent them
  • field offices - general agencies (headed by GA) and/or branch offices (agency manager)
  • GAs appointed by HO and considered independent contractors
    • usually receive expense allowance to cover office-type expenses
    • responsible for fin mgmt of agency
  • Branch Office - agency mgr gets assignment from HO and directly supervised by HO in fin mgmt of agency
  • difference between GA and agency manager has blurred
• Multiple Line (MLEA) and Home Service Agents
  • usually exclusive relationship w/ HO
  • MLEA also sell P/C products
  • MLEA has much higher agent retentino rate than career agents
  • Home service Agents - generally work in a debit (defined geog area)
    • works in lower-middle income mkts
    • all business is assigned to a servicing agent (eliminates "orphan" problem)
    • commissions generally NOT vested to writing agent

• Brokerage
  • mktg attempt to maintain relationships w/ producers whose primary affiliations are directed elsewhere
  • usually do not finance, train, or house agents who represent them
  • broker-insurer relationship - independent contractor
  • many variations on brokerage - specialized products, substd business, etc
  • brokerage supervisor - HO employee who contracts w/ brokers
• PPGA
  • contracted similar to how brokers are
  • co-employed regional directors (RD), MGAs (Managing General Agents) & direct contact via press
  • RDs and MGAs authorized to appoint PPGAs
  • PPGAs supply own office facilities
  • receive tech assistance in form of computers and adv sales support
  • usually have contracts w/ several cos
  • cu usually has min prod req to continue to receive tech support
• Marketing Organization - co contracts w/ independent org to mkt its products
• Wholesaling - co produces basic product and producer adds fees or commissions
• Producer Groups - groups of high-producing agents agree to place min amts of business w/ a co in return for a share of profits
  • usually through reins or stock options

• Overview
  • major components: FY/RY comm, asset-based comm, bonuses, exp allowances, security benefits
• First Year Commissions
  • expressed as combination of %FY prem, amt/polcy, amt/$1m, %CV
    • usually just % FY prem
    • often annualized & fully vested w/ chargebacks for early lapse
• Renewal Commissions
  • rate of compensation (usually % of prem), pattern of comp, conditions fro payment can be fully, partially, or non-vested
  • reasons for disparate nature of renewal comm scales
    • competitive concerns
    • regulatory constraints (ex. NY Section 4228G)
    • desire to improve persistency
    • direct agent's efforts in manner conducive to co philosophy
  • conditions for payment of renewal comm
    • renewal comm can be viewed as
      • deferred 1st year comp
      • reward for loyalty to co
      • payment (reward) for persistent business
      • payment for service to PO
      • start toward a retirement plan
• Asset-Based Commissions
  • aka trails
  • % of acct value/cash value
  • concept from stock/mutual fund world
  • more common on annuities
  • when on life, usually on UL/VUL products
  • not a significant source of income for newer agents
• Bonuses and other Compensation
  • bonuses focus agents attention on product profitability
  • various bonus measures
    • FY prem or commissions
    • net FY comm
    • total prems or comm
    • persistency (s/t and l/t)
    • # new clients or policies sold
    • combination
• Expense Allowances
  • usually a % of some mesure of slaes
  • sometimes based on renewals/persistency
  • used (in some cases) when agents pay some/all costs of office adn business expenses
• Security Benefits
  • a necessary and important part of overall compensation for career agents
  • includes live ins, health ins, dis, ret benefits, profti sharing, thrift or savings adn 401(k)
  • sometiems includes deferred comp options
  • covered under federal and state laws - OASDI, unemployment, workers comp
  • benefits ~ 16% of agent earnings
  • ERISA - probably biggest impacy adn most important - 1974
  • other acts include:
    • age discrimination - 1978
    • TEFRA 1982
    • DEFRA 1984
    • REA 1984
    • COBRA 1985
    • TRA 1986
    • OBRA 1987
  • FAS106 - 1990 req'd co's to carry retiree benefit costs as liab on fin statements
• Salary Compensation
  • usually restricted to new agents
• Differences Between Brokerage Contracts and Career Contracts
  • career agent usually considered a stat employee adn receives a W-2
  • broker compensation on 1099
  • brokerage contracts - normally no provision for fringe benefits
  • brokers commission schedules generally fully vested and pay rates generally below typical career agent
• Compensation for Internal Replacements
  • common methods for determing first year comm on internal replacemnt
    • % of full 1t yr comm where % increases based on dur of old pol, usually 100% after 10 yrs
    • full comm on increased prem, reduced comm on rest
    • difference between full FY and nwe and old
    • full FY if new prem > 2x old prem, otherwise %
    • full FY regardless

• high front-end commission structures palce persistency risk w/ cos
• level com shifts much of that risk to agents
• aligning agents' interestes w/ co may be what is needed ot arrest churning of business
• problem w/ transistions to level comm structures
  • increase in new agent fin cost since much lower early year comm
  • transitioning existing agents from high FY to levelized
• Possible solutions:
  • option to commute later year renewals to earlier years
  • adding add'l comp to existing business during transition
• Two major challenges
  • what will it cost to make this conversion
  • will change produce overall favorable results to co

• PC(n) - % of companies FY prem producted by agents in nth year of service
• O(n,t) - prob FY prem written by agents in nth YOS is from agents who will leave before policy enters year t
• O(t) - prob FY prem from agents who leave before business enters year t
  • =sum(PC(n)*O([n],t)
• P(t) = prob prem fro year t will be paid
• P(t)O(t) - prob that in policy year t, prem paid and agent no longer w/ co
• r(t) - nonvested renewal comm as % of prem
• cost of nonvested newnew comm = sum(r(t)*v^(t-1)*P(t)*[1-O(t)]
• To calc O([n],t)
  • l(n) = # agents entering nth yos
  • w(n) = # agents w/d from service in yer n
  • wq(n) = w(n)/l(n) = prob agent entering nth yos will w/d that year
  • PRD(n,s) = FY prem produced by one agent during their nth yos who will leave in their n+s-1th yos
  • O(n,1) = 0
  • O(n,t) = sum(PRD(n,s)*w(n+s-1)) / sum(PRD(n,s)*w(n+s-1)) where first term is summed from s=1 to t-1 and second term is from s=1 to infinity

• Overview
  • fundamental purpose of financing - make up difference between income needed (on a fair and resonable basis) and income initially earned under co's std basis of compensation
• Degree of Financing
  • depends on individual curcumstances
  • Aptitude
  • Preliminary Training adn Supervision
  • Company and Agency
  • Type of Commission Scale
  • Annualization of Commissions
  • Personal Circumstances
• Types of Financing Plans
  • Advances - loans made against future comm earnings
    • security against advances
      • comm on all business produced during financing period only
      • comm on all business, past and future, produced by agent
      • all fo agent's assets, incl commission earnings
    • rarely used
  • Subsidy - aka Training Allowance Plan (TAP)
    • payments, on a formula basis, in addition to comm
  • Salary
    • payments made in lieu of part (or all) of earned comm
• Validation Requirements
  • Validation Schedule - contains production requirements necessary to continue agent financing adn/or avoid contract termination
  • 3 basic factors to a validation schedule
    • expected growth rate in agent production
    • avg comm scale expected for financed agents
    • avg persistency and modal mix of business sold by financed agents (usually on premium basis)
  • need to know what to include/exclude from validation req
    • intercompany mktg agreements
    • subsidiaries
    • non-insurance products
  • efforts to reflect indiv performances
    • salary plan that pay comm on sales > validation reqs
    • shift from salary to subsidy plans
    • subsidy plans that pay variable TAP based on performance instead of initial salary level
  • some co's set up drawing accts to smooth out income fluctuations
    • aka line-of-credit plans
• Variable TAP
  • Advantages
    • production driven
    • agent experiences effect of production on income
    • less costly
  • Disadvantages
    • income can fluctuate more than for experienced agents
• Fixed TAP
  • Advantages
    • income stable as production increases
    • strong incentive to produce b/c comm paid
  • Disadvantages
    • high producers not rewarded proportionately
    • production does not have to be smooth
    • income can fall below income needs
• Line-of-Credit Plans
  • Advantages
    • income stable as long as acct cr/dr constant
    • large fluctuations in prod may still yield relatively stable income
    • fairly flexible by incorp adv from other types of plans
  • Disadvantages
    • agent could have decr in income after fin period b/c comm withheld
    • production doesn't have to be smooth
    • more costly due to development and admin
• Salary Plan
  • Advantages
    • Level income regardless of production
    • additional payments if production > certain limits
    • attractive to prospective agents
    • easier for mgmt to recruit
  • Disadvantages
    • high producers not always rewarded proportionately - may cause retention problems
    • costly if agents do not produce @ expected levels but continue on plan
    • income may change considerably when agent goes from salary to comm
    • requires close supervision adn strict adherence to validation scheds
• Estimating Financing Cost
  • avg financing level
  • validation schedule
  • agent retention rates
  • first year prems - estimates should include FY prems by agents who terminate w/in fin period
  • persistency rates and modal dist (freq of prem payments)
  • comm payments and subsidy payments
  • "unvested" recoveries - agents who terminate normally forfeit normally vested commissions on business written during fin period
    • "recoveries" normally subtracted from subsidy payments to determine fin costs
  • example p.IV-22
• Field Management Cost-Sharing
  • provisions for sharing cost and risk of fin new agent usually in GA's contract and now branch managers as well
  • Basic approaches
    • field mgmts share of the cost is highest in early part of fin period
      • discourages hast recruitment and careless selection
      • may carry marginal/failing agents until managers share becomes lower
    • field mgmt's share increases during financing period
      • mgr will continually evaluate prospects for sucess
    • field mgmt assums full cost responsibility from point when agent's production falls below some minimum validation level instead of requiring termination
• Home Office Supervision
  • agencies usually req'd to submitprogress reports on financed agents
• Evaluation of Financing Plans
  • criteria for evaluating effectiveness of plan
    • cost - ultimate excess of total payments over total comm
    • investment - amt outstanding at any time
    • simplicity of operation
    • understandability
    • degree of control
    • correlatoin between benefits and agents performance
    • dist of cost between co and GA or branch manager
    • likelihood of co's new agents meeting validation schedule
    • relationship of validation schedules to co's training porgrams
  • financing plan is ont substitute for training, supervision and sales assistance

• GO or agency manager - vital position in co's mktg org
• many responsibilities incl
  • recruiting/selection of agents
  • agent training/development
  • sales assistance and support
  • 2nd line mgmt development
  • business mgmt
  • agency planning and admin
• agency mgmt pay partly income for doing job and partly reward for taking risk
• five major categories of risk
  • development risk - associate w/ weighting various sources of business and productivity of source
  • persistency riks - assoc w/ payment/nonpayment of renewal prems and conservation of assets
  • expense risk - running the agency w/in certain standard for "controllable" expenses
  • product mix risk - multiple products w/ smaller exp loading and profit margins
  • time risk - delay between "virtuous activities" adn "result" that system rewards
    • may also be stabilization factors adn deferrals which futher separate reward from behavior
• General Ageny vs Agency Manager Systems
  • Theoretical Differences
    • GA is indep dist adn therfore assumes greater business risk in return fro greater l/t reward
    • 3 distinct types of GA contracts
      • general agency contract calls for specific overrideg comm to the GA and provides separately for the soliciting agent's comm
      • company pays comm to GA and PG pays to comm to agents - seldom used today in agency-building situations
      • PPGA contract primarily a producer contract
• Personal Production
  • regualar comm on personally produced business often not a substantial element of agency head's income
  • agency managers historically viewed as sales managers w/ principal responsibility to increase sales of co's products
    • expected to recruit/select/develop career agents whose perforamcne will help co achieve corp growth adn profit objectives
• Compensation Overview
  • Salary - exclusive to managerial systems since inconsisten w/ indep dist philosophy of GA approach
  • First-Year Overrides - motivate new sales
    • most sytems place significant rewards on this component
  • Renewal Overrides - usually paid in a GA system, less freq in a managerial system
  • provides CF stability to a GA and incentive for persistent business
• Vesting - usually subject to vesting provisions that give GAs ownership of future override streams if they leave co
  • originally intended to continue the return of invested capital after GA returned
• Service Fees - common in GA systems
  • orig established to cover prem collection and certain service functions
  • usually not vested
• Bonuses - do not usually vest
  • aka leverage elements
  • ex agency productivity, new agent organization, agency persistency, growth
• Expense Allowance/Business Management Factor
  • GA pays all expenses (in theory)
  • managerial approach - co provides agency office and support
  • GA expenses generally lower since he makes decisions based on actual CF
• Sharing of new Agent Financing Cost
  • loss-sharing assures better supervision and encourages more economical use of co resources

• "nontraditional" for life ins is mainstream in France adn Spain
  • half of US annuity mkt
• high cost of fact-to-face selling by trad ins agents forced most co's to upscale mkt
• middle mkt co's either abandoned mkt or chosen diff dist channel
• nontrad dist channels by mkt
• Middle Mkt
  • worksite
  • banks
  • direct mktg
  • internet mktg
• Upscale Mkt
  • fin planners
  • mutual fund salespeople
  • stockbrokers
  • accountants (CPAs)

• many reps used to be full-time agents in traditional system
• Financial Planners
  • negative perception of life ins agent - many got ChFC or CFA and advertise as fin planners/advisors/consultants
  • objective: to become trusted advisor providing full range of fin advice
  • growing number compensated on fee basis (vs commission)
    • fees: unpront to develop a written plan or asset-based
  • some states allow both fees & comm, some states say either/or
  • few ins cos make fee-based fin planning a primary strategy
    • potential liabilities, admin costs, potential conflict between independent advice and sale of proprietary products
• Stockbrokers adn Mutual Fund Salespeople
  • VAs a natural extension b/c of tax advantages vs stocks/bonds/mutual funds/etc
  • stockbrokers most significant source of VA sales
    • not as sucesful selling life ins
  • grid-based compensation systems - consistent w/ evolving needs of distributors & producers
    • grid approach - gross dealer concession - gross dist margin
• Accountants (CPAs)
  • enjoy high degree of respect and integrity in eyes of ins buying public
  • clients good opportunities for 2nd-to-die life, annuities, and mutual funds
  • traditionally good source of referrals
    • if not selling themselves, expecting agents to split comm w/ them
  • very influential in fin affairs of high net worth clients

• Worksite Marketing
  • aka voluntary benfits
  • mktg personal ins products to EE at their place of work
  • products endorsed by employer that EE decides whether to purchase
  • ER cooperation needed to initiate sales process and implemet payroll ded plan for EE prem payment
  • insurers view as way to reach underserved potential clients in a cost-effective manner
  • agents view as either primary or secondary mktg focus. For both
    • provides daytime selling opportunities
    • large prospecting list
    • fresh "door opener" conversations w/ decision makers
  • EE view
    • discounted rates
    • convenient, non-intrusive slaes process
    • policy portability
  • usually low min prems and guar iss/simplified u/w
  • 3 ways to present and enroll
    • agent (or salaried enroller) meets w/ EE 1-on-1 at work
    • group settings
    • payroll stuffers/direct mail
  • account admin is most critical factor to determining effectivness and success of program
    • depends on ability of payroll deduction
    • systems must be able to accomodate w/o add'l ER expense
  • pricing requires special knowledge and u/w assumptions that allow for attractive profit margins
    • requires close monitoring of actual experience
• Banks
  • increasingly important for annuities
  • 3 main strategies for bank annuities
    • licensed platform staff - specially trained bank employees
    • in-branch (bank) agents - usually work for Bank's ins agency subsidiary
    • third-party agents
  • some mkt annuities through b/d or securities units
  • some use direct mktg methods
  • life ins sales not as sucessful as annuities < 1% total life sales
  • reason for poor life sales
    • regulatory constraints (eased by passage of GLB)
    • u/w process an annoyance banks not used to dealing with (collecting blood, etc)
    • planning for a negative life event vs savings for home or college
    • banks used to transaction sales adn life ins not a transaction sale
  • Compensation
    • most bank producers paid base salary w/ some form of incentive
    • banks hesitant to have sales force paid solely on incentive basis b/c of fear of agressive sales tactics
    • since prospecting not an issue, don't need to compensate for that
    • banks usually compensated by LIC via commission
    • other methods
      • expense reimb & allowance
      • override
      • lease paymenets for use of bank office space
    • incentive for non-licensed bank personnel for lead generation
  • Bancassurance in Europe
    • very succesful in Spain (50%) and France (60%)
• Direct Mktg (aka Direct Response)
  • uses one or more media to elicit an immediate and measurable response
  • records, tracks and analyses that action
  • stores info about action in database for future retrieval and use
  • methods
    • direct mail - tech allows to be highly targeted adn personalized
    • print media
    • broadcast media - select shows/times to hit target mkts
    • telemktg - outbound and inbound (primarily to support other direct response media by processing responses)
    • fax mktg
    • retail centers and kiosks
    • internet dist methods - own site or aggregators
  • traditionally used for consumers not served by personal selling dist systems
    • need only limited or supplemental ins
    • live in geog remote areas
    • need products not widely avail from most co's, agents, brokers
    • need products whose comm potential is too small in relation to an agent's personal selling efforts
  • Tarket mkts also includes indiv who can be easily reached b/c belong to special into or consumer groups
    • company's own customers
    • consumers who have prev inquired about a co's products
    • consumers who have prev inq about another co's direct mktg offer
    • members/vets of armed forces
    • hold dept store or bank credit cards
  • Credit Card holders and SR Citizens frequently targeted

• Persistency
  • Short-term Persistency
    • generally measured using lapse rates based on face/# pols/prem
      • # pols = # decisions to lapse
      • prem - better measure on fin impact
    • most common def of s/t lapse - policy that fails to pay 1st prem of 2nd policy yr (aka 13th mo) for reasons ofther than lapse/conversion
    • early lapse rate stressed b/c
      • fin impact on eraly terminations greater than later terminations
      • early lapse primary indication of if business being sold efficiently
      • early lapses most susceptilbe to chagne by direct co effort
  • Long-term Persistency
    • loss of older business significantly affects profits, div scales and current pricing
  • Establishing Persistency Objectives
    • consider effect of req'd effort on dist channels and on co fin results
    • agents must allot their time between pursuing NB adn servicing old business
      • keeping in mind potential monetary payback
      • if measures to imporve persistency reduce expenses, but production inhibited to point where cost/unit actually increases, no fin gain has resulted
  • Factors Affecting Persistency
    • Income and mode of prem payment are major factors related to persistency
    • MDB close to same as annual b/c of automatic nature
    • buyer-related: higher than average persistency among
      • older
      • professional adn executives
      • already own ins w/ same co
      • insuring lives of juveniles/students
      • initiating sale themselves
    • Product Related: higher than average persistency
      • perm vs term
      • higher prem and/or acct value (cv plans)
      • w/o policy loans
      • u/w on med basis
      • sold w/ insurability option
      • larger PRD policies
      • business vs personal policy
      • issued as applied for
      • sold w/ wvr in home service mkt
    • Producer Related
      • persistency incr as agent's YOS incr
      • new agent terminators sell business w/ poor persistency
      • positively related to agent's product knowledge
      • persistency obnuses have intended effect
      • orphans - good business lost b/c lack of contact
        • poor agents selling poor business
    • Sales Process Related - higher lapses when
      • partial or no cash w/ app
      • needs selling not employed
      • agent stresses savings and thrift
      • policies not deliverd personally to insured
      • post-sale service not employed
    • Related to Outside Environment
      • persistency poorer during high unemployment and high int rates
      • persistency improves when personal savings adn eff buying incomes high
      • growing competition from competitive inv media incr replacements
      • better persistency in mid-Atlantic and Norther part of US
• Replacements
  • reasons why PO may consider replacing existing coverage
    • reduced prems
    • volume discount
    • flexibility
    • interest rates
    • insurer's financial health
  • factors to consider when determining if replacement in PO best interest
    • FY acq expenses
    • Increased prems
    • Values in existing pols
    • suicide adn contestable provisoins
    • new-money plans vs Trad plans
    • tax consequences

• most same info as life
• Persistency
  • measured using surrender rates based on contracts or CV
  • SC relatively effective @ preventing surrender activity when in effect
  • surr rates increase when charges expire (aka shock lapses) & tend to remain higher
  • dist channel has major impact on annuity persistency
  • SPDA shock lapse rates lowest->highest career agents/banks/ind agents/stock brokers
• Replacements
  • reasons to replace annuity contract
    • change of investment risk tolerance
    • cost
    • product perforamnce
    • product features

• loyalty perspective - whole copmany perspective
  • potential for quantum leap gains in persistency
• tweaking - relatively small improvements can have large financial gains
  • financial incentives - sales reps and/or customer a persistency bonus
  • compensation for persistency - reducing FY and increase RY comm
  • continuous educatoin - educate PO about purchased products
    • reduces risk of "escalator effect" - switch products to participate in recent performance of stocks/bonds w/o consideration to their risk tolerance or LT goals

• strategies to combat replacements
  • aggresive pro-active measures by formal conservation unit
  • computerized detection system to indentify internal replacements
  • inform sales reps when policy about to lapse
  • guidelines to sales reps to id potential replacement situations
  • educational materials and sample letters for sales reps to use
  • provide service to former sales reps who service policies
  • compensate sales reps for high retention thru persistency bonuses, incentives, recognition programs
  • do nothing - may be OK for some blocks, but may send wrong signal to field
  • increase face for existing policy. costs s/b offset by improved profits
  • decrease premium for existing policies. costs s/b offset by improved profits
  • set up loan repayment program or exchange program for special cases
  • keep product protfolio attractive and flexible
    • selling good product reduces chance of replacement
  • provide quality customer service

• consumer level - competing against otehr cos w/ similar products
• distribution level - compete for agents or other sales sources
• inter-industry competition - consumer savings and retirement dollars
• mainly focused on price comptetition adn disclosure regs
• price comparison - measures relative attractiveness of pols avail from diff cos
• policy benefit disclosure - informing prospects of structure of policy offered
  • prems, CVs divs, options and supp benfits
• life ins is usually "sold" instead of "bought" - different from most consumer products

• old std basis - net cost = sum prems for 20 years - 20 yr CV - illustrated divs
• 70s - suggesting int adj cost index
  • slow acceptance b/c
    • controversy over choice of new cost comparison system
    • apprehension that emphasizing comparative costs might hampter selling and discourage prospects from buying
    • failure to sufficiently recognize risks of buying needed coverage
    • failure to sufficiently recognize the risks of delay
  • feds started looking @ alternate indexes and spurred cos to react
  • ind adj finally adopted by NAIC in 76
  • myth: cost alone is basic comparison factor among ins products - int adj method perpetuates this
    • doesn't help buyers assess appropriateness of product to their needs
  • consumerists often forget that one of the benfeits for buyer is education and services of a professional agent
  • efforts to improve quality and availability of comparative info ineffectove for several reasons
    • failure by industry leaders (and actuaries) to recognize delay may lead to widespread buyer rejection of ins
    • problems in comparing dissimilar policies - policy types adn company philosophies (new money vs portfolio)
    • agent's ability to vary illustrations - esp int racditing rates
    • actuaries who confuse illustrations w/ projections and reject any form of comparative analysis
    • regulators and regulations that have not kept pace w/ products

• historically used to show effects of dividends
• b/c of external copetition, began using illustrations to show inner workings as comparison to external products
• tech alloed agents to produce illustrations on the fly
• if done on a consistent basis, illustrations provide valid comparison
• abuse of illustrations have caused may problems

• NAIC working group indentified # of computer illustration problems
  • inappropriate use of illustrations to estimate future performance and compare policies
  • lack of accountability of any of the parties to the sale
  • lack of standardized format fo rlife ins illustrations
  • lask of std and consistent definitions, lang, assumptions adn methodology
  • inadequate description of the policy
  • consumers not notified of changes in current assumptions
  • insufficient penalty provisions exist for disclosure violations
  • current regulatory approaches out-of-date considering desings of poliices being sold today
• NAIC Life Ins Illustration Model Reg - app 1995
  • provided for protection of consumers
  • fostered consumer education by making illustrations understanbable
  • provided illustration formats
  • prescribed standards
  • req'd disclosure in connection w/ illustrations
  • created illustration actuary
• Illustration Actuary - certifies illustratoin based on ASB standards
• ASOP 24 provides guidance
• "Illustrated Scale" must be supportable (disciplined current scale)
  • to appease regulators concerns over "bait and switch" scales (non-guar elements)

• policy form should not be supported by another policy form or another source
• accumulated value of policy CF using disciplined current scale and underlying assumptions s/b >= illustrated PO valued for 15th anniv and every illustrated point beyond

• req prohibits illustration of non-guar elements in poliicies deemed lapse supported
• req degined lapse-support test - used disciplined scale assumptions except years 6+ assume 100% persistency
  • intended to insure that any persistency bonuses included in test

• disciplined current scale assumptions s/b based on actual experience to extent experience is current, determinable, and credible
  • otherwise use actual exp/trens of similar blocks from
    • same co
    • other co
    • other sources
    • in above order
• major experience factors
  • interest mortality taxes
  • direct sales costs all other expenses persistency
  • aggregation reinsurance changes in methodology
• model req defines min expenses w/ 3 option approaches
  • approach must be used for all policy forms during certification year
    • Fully Allocated Unit expenses
    • Marginally Accocated Unit Expenses
      • similar to fully but excluded corp overhead adn general adv
    • GRET
  • marginal only to used if > GRET
  • GRET can only be used if > marginal (in aggregate)
  • can always use fully allocated as minimum
  • cannot project favorable trends into future
  • Illustration Actuary needs to certify scale
    • scale has not changed since last certification and experience doesn't warrant changes OR
    • scale has changed since issue only to extent chagnes are reasonably consistent w/ changes in exp assumptions underlying current disciplined scale OR
    • currently payable scale has been made less favorable to PO since last certification and change is more than current experience would necessitate
  • Illustration Actuary should certify annually
    • and for newly introduced forms before new policy form is illustrated
  • certification should contain
    • for business issued in last 5 years, if currently payable scale as been reduced since last cert for reasons unrelated to exp changes
    • statement as to whether inconsistency between illustrated non-guar elements for new policies adn similar inforce policies
    • statemetn whether illustrated non-guar elements for new and inforce pols consistent w/ non-guar element amts actually credited or charged to smae or similar forms
    • statement as to choice of expense assumptions

• 1/s(n|)*[sum([t]P(x)*(1+i)^(n-t+1)) - sum([t]D(x)(1+i)^(n-t)) - [n]CV(x)]
• P - prem, D - Div
• originally 4% in US, 5% in Canada, now 5% in both
• if i=0, Net Cost Index is result
• NAIC model REg Int Adj Payment index - same formula in book, but use 0 for yield

• gibbersih in book

• solves for a level effective int rate or yield
• compares a level prem policy to a term adn invest such that investement @ solved for rate = nth yer cash value

• commonly used w/ "leveraged" COLI policies
• only appropriate for sophisticated buyers

• Actuaries' Index is a "group-average" type adn other methods are "event-specific"
  • "group average" - average cost to a group of PO
• main objection to "group avg" - employs probabilitys that represetn avg and therefore not applicable to many of the buyers who rely on the result
• main objection to "event specific" - likelihood of chosen event occurring is rather small

• N/a to
  • variable life
  • ind and gruop annuities
  • credit life
  • life policies w/ no illustrated DB > 10k
• disciplined current scale - reasonably based on actuarl recent hist exp
  • does not allow projected improvements
  • does not allow assumed expenses < minimums
• illustrated scale - lesser of
  • disciplined current scale
  • currently payable scale
• lapse-supported illustration - disciplined current scale ecxept 100% persistency years 6+
• min assumed expenses
  • fully allocated expenses
  • marginal expenses (only OK if > GRET)
  • GRET
  • if no approved GRET, must use fully allocated
• self supporting illustration - accum CF >= PO value (CV adn other available amts) for 15th policy yer & all illustrated points beyond
  • 20th yer for 2nd to die

• can't use an illustration prior to 1st anniv if policy form marketed w/o illustration
• if mktd w/ illustration, illustration must follow reg
• quotations for non-term group life: show sample age values <> illustration for purposes of reg
  • but illustrated values must be consistent w/ illustrated scale
  • basic illustration must be available to any non-term gruop life enrollee who requests it
• General Rules and Prohibitions
  • labeled "Life Ins Illustration" adn contain basic info
    • name of insurer name adn address of sales rep
    • name/age/gender of prospect u/w/rating class illustrations base upon
    • generic & company prodict name and form #
    • initial DB dividend option election or application or non-guar elements
  • shall NOT
    • represent pol as anything other than life ins pol
    • use or describe non-guar elements in a misleadaing manner
    • state or imply that non-guar elements are guar
    • use a non-compliant illustration
    • use an illustration more favorable than reality
    • provide an incomplete illustration
    • represent that prem payments not req'd to maintain illustrated DB unless that is true
    • use "vanish"
    • use "lapse-supported" illustratino, unless prodcut has no non-f benefits
    • use a non-self-supporting illustration
  • int rate can't be greater than disciplined scale rate

• Format
  • boat load of caveats adn supplemental explanations for anything not guaranteed
  • have date prepared and page # of ##
• Narrative Summary
  • brief descriptoin of policy
  • breif desc of prem outlay
  • brief desc of policy features/riders/options
  • identification adn brief def of column headings and key terms
  • not-guaranteed caveat
• Numeric Summary
  • Pol years 5,10,20,AA70
  • Policy guarantees
  • insurer's illustrated scale
  • "mid-point" scale
    • divs @ 50%
    • credited rates @ avg guar & illustrated
    • non-guar charges @ avg guar & illustrated
• Statements
  • one signed by applicant/PO
  • one signed by sales rep
• Tabular Detail
  • basic illustrations
    • every year 1-10 adn 5th year thereafter
    • any year premium outlay changes
    • prem outlay and mode of payment
    • guar db
    • guar csv
    • non-guar elements may be shown if described in contract
      • must show at same durations
      • must show 0 in guar column

• must be associated w/ basic illustration
• can't show values more favorable than basic illustration
• non-guar caveat
• must include notice to look @ basic illustration

• copy if signed illustration attached to app
• revised illustration need to be signed if policy issued other than applied for
• agent must sign if no illustration used and illustration provided w/ policy
• signed illustration must be kept in file for 3 years after policy no longer in force

• Illustrated policies must provide annual status reports
  • UL
    • beg adn end odate of report period
    • pol value @ end of last and current period
    • total amts credited/debited - by type
    • current Db
    • CSV
    • loan balance
    • lapse notice - if applicable
  • Other Pols
    • current DB
    • ann prem
    • current CSV
    • current DIV
    • applicatoin of current div
    • outstanding loan
  • if pol has no nonf values, only need to supply annual report when change made to non-guar elements

• Illustration Actuary - appointed by board of directors
• Ill Act will certify that illustrations in compliance
• Illustratio Actuary is
  • MAAA
  • familiar w/ illustration ASOP
  • not been bad - from an illustration actuary perpsective
  • disclose material changes in scales/assumptions
  • disclose expense assumptoin
  • certify policy forms annually adn before first use
• another responsible officer certified
  • illustrations in use are ones Ill Act certified
  • co gave agents info about expenses
  • company will promptly inform when and why illustration actuary changes

• professional responsibility of member to public - don't mislead
• familiarity w/ users and uses of sales illustrations - who are users and what is purpose
• determination of range of primary scenarios - ensure ranges are reasonable
  • based on policies, practices adn expereince adn economic environment
• demonstrate reasonable sensitivity - pick an alternate scenario to demostrate sensitivity of policy to changes in experience
• documentation

• historical results s/b adjusted for current factors
  • ex Investment Income Tax, current tax law, current expense levels adn margins for profitability, compensation, etc
• historical results s/b adjsuted for unique/one-side factor
  • impact of declining canadian $ on international inv yields
  • temporary dividend enhancements
• co's intended management of product
• caveat that primary scenario is NOT prediction of results
• scenarios shoudl encompass all exp factory which might materially impact results
• caveat that alternate scenario is NOT worst case scenario
• info on variability of results
• also consider
  • policy provisions
  • company practice
  • potential impact of illustration on PRE
  • ease of implementation of new scenarios
  • whether product is lapse-supported
• consistency between assumptions used in scenario
• consider product special features
• for par dividend scales, consider
  • trends in inv returns
  • compositoin of portfolio of assets
  • investment adn div policies of co
  • recent co experience on factors impacting div scale
• for UL consider
  • guar credited rates
  • LT avg of inv returns by major inv options
  • availability and use of hedging fo rindex-linked inv options
  • guar mort andtoehr charges
  • int credited copared to cgross inv returns
  • recent co experience which might impact spread
• for toher products
  • recent adn anticipated experience in factors affecting results

• co's valn report
• co's long range plan
• economic forcasts
• spot yield curves
• CIA economic statistics
• historical results as reported by organiztions such as S&P, Morgan Stanley, etc

Pricing

• Calc in 3 steps
  • pre-tax solvency earnings
  • deduct taxes to detmine after-tax solvency earnings
  • adjuste after-tax solvency earnings for incr req captial and add after-tax inv income on assets backing req'd capital
• Pre-Tax Solvency Earnings
  • product cash flow - ProdCashFlow(t) = Prem(t) - Ben(t) - Exp(t)
  • adjust for reins if necessary
  • increase in solvency reserves - SolvResIncr(t) = SolvRes(t) - SolvRes(t-1)
  • investment income - InvIncome(t) = PolLoanInt(t) + InvInc(t) + CashFlowInt(t)
  • PreTaxSolvEarn(t) = ProdCashFlow(t) + IncIncome(t) - SolvResIncr(t)
• After-Tax Solvency Earnings
  • AfterTaxSolvEarn(t) = PreTaxSolvEarn(t) - Tax(t)
• Adjustment for Req'd Capital
  • ReqCapIncr(t) = ReqCap(t) - ReqCap(t-1) -> increase in req'd capital
  • ATInvIncRC(t) = InvIncRC(t) - TaxInvIncRC(t) -> after tax inv income on assets backing req'd cap
  • DistEarn(t) = AfterTaxSolvEarn(t) - ReqCapIncr(t) + ATInvIncRC(t)
  • often not practical to price over lifetime of product, instead use 10/20/30 years
  • if n is pricing horizon, need to account for all profits beyond n
    • release req'd capidal @ end of n (ReqCap(n) = 0)
      • either explicitly or set lapse for n to 100%
    • present value of all future events need to flow through year n calc

• solvency reserves distort profit w/ significant NB strain, earnings reserves have smoother pattern, often no loss in first year
• Pre-Tax Stockholder Earnings
  • similar to pre-tax solvency earnings
    • product cf are identical
    • main diff: change in earning reserves (net of DAC) vs change in solvency reserves
    • assume invested assets = solvency reserves + req'd capital
  • PreTaxStockEarn(t) = ProdCashFlow(t) - BenResIncr(t) - DACAmort(t) + InvIncome(t) + InvIncRC(t)
  • DACAmort(t) = DAC(t-1) - DAC(t) where DAC(0) = 0
  • From Solvency Reserves
    • PreTaxStockEarn(t) = PreTaxSolvEarn(t) + SolvResIncr(t) - BenResIncr(t) - DACAmort(t) + InvIncRC(t)

• need to deduct 3 components of tax
  • Tax(t) - PreTaxSolveEarn tax
  • TaxInvIncRC(t) - Tax on Inv Inc earned on assets backing req cap
  • DefTaxProv(t) - Tax on diff between shareholder and solvency earnings excluding II on req'd capital (aka Provision for Def Taxes)
• AfterTaxStockEarn = PreTaxStockEarn(t) - Tax(t) - TaxInvIncRC(t) - DefTaxProv(t)
• Positive Distributable earnings - max amount that can be paid to stockholders
• Negative Distributable earnings - capital contributions stockholders must pay into co
• After-Tax stockholder earnings - earnings reported to stockholders
  • often exeeds distributable earnings for a growing co

• After-Tax stockholder earnings / stockholder equity base
• stockholder equity base
  • stockholder equity @ BOY OR
  • avg of BOY and EOY stockholder equity
• stockholder equity = Assets - Liab
• Assets = DAC + inv assets backing solvency reserve + req'd capital
• Liab = benefit reserves + def'd tax liab
• StockAssets(t) = SolvRes(t) + ReqCap(t) + DAC(t)
• StockLiab(t) = BenRes(t) + DefTaxLiab(t)
• StockEquity(t) = StockAssets(t) - StockLiab(t)
• EquityBase(t) = StockEquity(t-1) or 0.5*(StockEquity(t-1) + StockEquity(t))
• ROE(t) = AfterTaxStockEarn(t) / EquityBase(t)
• ROE varys by year therefore tough to determine if co's ROE goal is met over product lifetime

• basic questions
  • which acctg basis to calc profits
  • how to reflect products degree of risk
  • what rate to discount future values or as targeted rate of return
  • should impact of req'd capital be reflected (authors assume yes)
• Choice of Acctg Basis
  • solvency earnings
    • important to regulators and rating agencys
    • solvency reserve and cap req drive shareholders investments
  • stockholder earnings
    • if co places heavy emphasis on stockholder earnings
    • added difficulty so not as popular
• Reflecing Risk in Profit Goals
  • profit goals related to risk (more risky, higher profit margin)
  • possible ways to reflect risk
    • formula that might reflect lapse/mort/exp/inv risks
    • profit margin set to estimated degree of risk
    • sensitivity analysis to estimate degree of risk and set profit margins
  • examine product design adn origin of assumptinos used to id risks that req special treatment and possibley make design chagnes to minimize risk
• Choice of Discount Rates adn Rates of Return
  • factors to consider when choosing discount rate
    • company's cost of capital - weighted avg and marginal
    • "opportunity cost" of capital - what could they earn if that money was elsewhere
    • current capital position adn expected capital position over next few years - might be receptive to lower yield s/t opportunities
    • how will discounting be used
      • generally based on cost of capital or opportunity cost
      • if discounting to give more weight to early years, pretax or after-tax yields on inv assets may be appropriate
    • rate-of-return rate that discounts the stream of profits to zero
    • it taxes are level % of pre-tax profits, pre-tax and after-tax rates of return are same

• PVPrem = sum(Prem(t)*DiscFactor(t-1)) => t-1 b/c prems paid at BOY
• PV(var,n) = sum(var(t)*DiscFactor(t)) over n years
• if some PVFP < 0 [ i(t) - normal disc rate j(t) - discount rate when profits are neg - typically after-tax int rate earned on invested assets]
• PVFP(n) = Profit(n)
• for t = n to 1 step -1
  • If PVFP(t) > 0 then
    • PVFP(t-1) = PVFP(t)/(1+i(t)) + Profit(t-1)
  • else
    • PVFP(t-1) = PVFP(t)/(1+j(t)) + Profit(t-1)
  • endif
• next
• PVFP(n) = PVFP(0)
• if n = 1, Profit(0) = 0

• Overview
  • Embedded Value Return on Investment (ROI) Weighted-avg return on equity (ROE)
  • Profit as % of Prem/Assets/revenues/risk charges
  • Accum Porift at % of reserves breakeven year new business strain
  • most co use ROI or ROE along w/ profit as % of prem
  • publicly traded stock cos tesnd to use embeddev value, ROI/ROE as one of their profit goals - each involves a targeted rate of return
• Embedded Value (aka value added)
  • simplest measure - only one decision - hurdle rate
  • hurdle rate - rate of return owners expect
    • s/b in line w/ weighted avg cost of capital for stock co
    • s/b consistent w/ return avail on investments of comparable risk
  • normally base profits on after-tax solvency earnings or distr earnings
  • distr earnings better reflect owners' expected cash flows
  • EmbeddedValue(n) = PV(Profit,n)
• Return on Investmetn (ROI)
  • solved for discount rate that causes PV Profits = 0
  • normally base profits onafter-tax solvency earnings or dist earnings
  • Dist earn preferrable - better reflects owners' expeced cash flows
  • ROI can be primary or seconday profit goal
  • ROI fails if all policy years are profitable
  • posses in later years can olso produce meaningless ROI
  • Simple ROI
    • 0 = sum(Profit(t)/(1+i)^t and solving for i
  • Multiple ROIs
    • # positive roots of polynomial = # sign changes of Profit(t)
  • Generalized ROI
    • if muliple sign changes, use an int rate for borrowed money (j(t)) adn use iterative process to solve for i
      • PVFP(t-1) = PVFP(t)/(1+[i(t) or j(t)]) + Profit(t-1)
• Weighted-Avg Return on Equity
  • calculate a weighter avg return = (after-tax stockholder earnings) / weighted avg equity base
  • can weight by discounting using ROI goal or hurdle rate
  • can link to targeted growth rate
  • WtdAvgROE(n) = PV(AfterTaxStockEarn,n) / PV(EquityBase,n)
  • hopefully each policy year ROE approx = WtdAvgROE
• Profit as Percentage of Premium
  • one of most common profit measures
  • advantage: fairly concrete and easy to explain
  • common to use pre-tax or after-tax int rate eaerned on assets for discounting
  • using ROI or Hurdle rate, PVProfits approx = 0 therefore meaningless
    • this logic applies to all measures that compare PVprofit to another measure
  • Proft%Prem(n) = PVProfit(n) / PVPrem(n)
• Profits as Percentage of Revenue
  • generalization of Profit%Prem
  • useful mainly as way to compare relative profitablilty of similar product types
  • NOT useful at comparing two diverse products
  • not all products use premium as important soure of revenue (ex. UL -> inv income and charges)
• Profits as Percentage of Assets (aka Return on Assets or ROA)
  • many product priced w/ targeted spread between rate earned and rate credited
  • useful to know how much of spread (on avg) retained as profits
  • numerator and denominator need ot be in sync
    • after-tax solvency earnings <-> solvency reserves
    • dist earn <-> solv reserves & req'd cap
    • after tax stock earnings <-> solv resv & req'd cap & DAC
  • ROA(n) = PVProfit(n) / PV(Assets,n)
• Profits as Percentage of Risk Charges
  • Risk charges -attempt to quantify degree of risk inherent in product
    • may consist of mortality, lapse and inv components
    • simpler: risk charge as % or req'd capital (assuming req'd capital is accurate measurement of risk)
  • no std approaches
  • PVProfits(n) / PV(risk charges,n)
  • attraction: compares profit to risk
  • detraction: may be illusion since risk charges somewhat arbitrary
    • difficult to explain concept to management
  • Risk-Free Rates and Risk Charges
    • investors want higher reterns for higher risks
    • minimum rate of return for risk free investment
    • goal to developing meaningful risk charges - profits net of risk charges earn risk-free rate
    • w/ PV based on risk-free rate, PV(Profits) = PV(Risk Charges)
    • use industry avg rates of return to establish appropriate level of risk charges
      • ensures pricing roughtly in line w/ rest of mkt
• Accumulated Profit as Percentage of Reserves
  • one of earliest profit goals - primarily mutuals
  • goal - one generation of PO provides capital to fund next generation
  • rarely used (currently) for new products
  • sometimes used for setting div scales
  • usually after tax solvency earnings and usually after-tax int rates
  • AccumProfit(n) = sum(Profit(t)*AccumFactor(t))
  • AccumProfitPct(n) = AccumProfit(n) / Res(n) where Res(n) is appropriate reserve
• Breakeven Year
  • Policy year when accum profits first turn positive adn remain positive
  • more of an indicator or danger signal than profit measure
  • Modified Breakeven Year - assume all policies lapse at end of given year, releasing req'd capital and excess reserves inro profit calc
    • first yer w/ accum profits (including releases) is modified BE year
  • late BE year may be acceptable for mutual
  • req'd as part of US Illustration Reg supportability test
• New Business Strain
  • Not truly a profit measure
  • often evaluated as part of pricing process
  • often converted to % 1st yr prem
    • coupled w/ prem projections, can easily estimate capital necessary to finance NB
  • NBStrain = DistEarn(1) / Prem(1)

• Overview
  • create financial model by combing results of numerous ages and risk classes
  • multiply per-unit-issued results by wieghts for dist of business by age adn risk class and summarize the weighted results
  • General Steps
    • calc results on per-unit issued basis for a number of cells
    • multiply each cell's per-unit-issued results by appropriate # units -> gross results/cell
    • sum up gross results to calc total model results
• Uses of Liability Models
  • heavily for product decisions - including feature design and price structure
  • combined from several products -> entire product line
  • decide to introduce new product/discontinue existing one
  • assess value of block of business to be acquired/sold
  • essential tools to decide to continue/sell/close down LOB or Co
• Types of Liab Models - purpose of model will determine scope/size/complexity
  • Pricing Models
    • prelim models typically few representative IA/sex/risk/pol size cells w/ highest expected sales
    • final models include complete range of representative ages
    • often use refined models for bulk of pricing and simplified methods to handle rest
    • usually necessary to develop rates for all rep IA for both genders for at least some subset of cells
    • allows you to cross-subsidize results between pricing cells
      • higher profits from most cells may support lower profits at one or two key cells
  • New Business Models
    • for planning and budgeting purposes
    • project amt and fin impact of NB
    • more useful - model that reflects effect of exp NB from all major products
    • usually sufficient to model results of co's best sellers and gross up
  • InForce Models
    • uses
      • combined with NB models for planning/budgeting
      • calc value of block to be sold/acquired
      • determine adequacy of reserves
      • test reasonableness/equity of revised div scale/COI rates/int crediting strategy
      • project future liab CF to maatch asset CF
    • similar products usually grouped together
    • law of diminishing returns - additional accuracy gained not worth time it takes to model the next product
    • maybe vary issue ages modeled - fewer for smaller products
• Building Data for Liab Model
  • type type of data input: aggregate and cell data
  • aggregate data
    • few assumptions, assumption multipliers and other parameters
    • easily changable
  • cell data
    • mainly product parameters and assumptions
    • assumptions in cell data include mort rates/lapse rates/expense rates/avg size/# units
  • many assumptions from pricing assumptions or recent experience studies
  • avg size/# units usually from inforce data
  • many cos use purchased modeling software
    • extract used to input to liab model - normally cnotains plancode/issuedate/IA (or DOB)/sex/risk class/units/SAPVx/TaxVx/AcctVal(ul)/Amt Reins
  • Liability Model Calculations
    • want model to reasonably approximate fin statement results, therefore cal yr results
    • may need quarterly projects for plan/budget
    • book assumes 1/1 issue date to ease calendar year reporting
    • can group data so 1/1 is avg issue date
  • Model Variables
    • calyr = issyr + t - 1 where t is policy year
    • issyr = calyr - t + 1
    • t = calyr - issyr + 1
  • Number of Units
    • reflects distribution of business among cells
    • NumUnits(c) - # units for cell c (# issued)
    • NumUnitsIF(c) - # units inforce @ start of model for cell c
    • NumUnits(c) = NumUnitsIF(c) / SurvFactor(c,begyr-1)
    • if SurvFactor(c,begyr-1) = 1, above adjustment not necessary
  • Total Results
    • variable_tot(calyr) = sum(variable(c,calyr)*NumUnits(c))
  • Cell and Total Calculations
    • cash flows, reserves, reins calced @ cell level
    • ii, taxes, req'd cap, profit measure could be calced @ cell or total level
      • calcing @ cell level
        • probably slower
        • makes summarization simpler adn more flexible
      • calcing @ total level
        • more contol over final results
        • Quickly adjust total only parameters adn recalc results
• Validating a Liability Model
  • essential to validate prior to use
  • NB or Pricing - compare ratios/patterns over time
  • Inforce Model - reproduce starting inforce #s
    • static validation - reproducing actual values @ given point in time
  • ways to improve model
    • changing representative issue ages
    • adjusting avg issue date
    • splitting into more issue periods
  • after initial inforce validated - reasonability of model going forward
    • test model using inforce from year-1 and compare to actual results
  • validating over a period of time - dynamic validation
  • instead of tuning assumptions, sometimes just make adjustments @ total level
• Liability Model Output
  • commonly rows for each result and coulms for time periods
  • s/b organized into familiar and useful formats, such as I/S or B/s
  • other common outputs include
    • product cash flows - useful for planning inv strategies
    • inventory reports - ins inforce, # pols inforce
    • AmtInfIF(c,calyr) = DB_pu(c,calyr)*NumUnits(c)*SurvFactor(c,calyr) (_pu is per unit)
    • NumPol(c) = NumUnits(c) / AvgSize(c) where AvgSize(c) = avg # units / policy issued
    • NumPolIF(c) = NumPol(c)*SurvFactor(c,calyr)
    • AmtInsLapsed(c,calyr) = DB_pu(c,calyr)*Lapses(c,calyr)
    • Annualqw(calyr) = AmtInsLapsed_tot(calyr) / AmtInsIF_tot(calyr - 1) -> annualized lapse rate
• Total Profit Measures
  • w/inforce data included, can onlyl calc meaningful results for ROI, ROE, adn EV
  • EV can be calced sep for inforce and each future issue year
• Aggregate Models
  • over short-term - relatively simple aggregate models commonly outperform elaborate cell-based models
  • focus on growth rates adn trends of ratios
  • ex. Income Stmt items as % of prem - probably see stable relationships and clear trends
  • some kinds of business better predicted as % of assests or some other base
  • no std approaches to aggregate models
  • aaggregate models are poor predictor if co makes significant changes
  • best models combine s/t fit of simple aggregate models w/ long term predictive capability of cell-based models
  • once it is understood how to adjust s/t results to better match aggregate results, same techniques can be used to adjust l/t results

• Purpose of A/L Modeling
  • design investmetn strategy that fits product/liab portfolio
  • more accurately predict inv income
  • determine potential effect of diff int rate scenarios
  • test strategies used to set credited rates
  • asset modeling is driven by inv strategy, but informed inv strategy can only be develped once cash flows have been estimated
• Designing an Investment Strategy
  • most non term products depend heavily on investment returns
  • Predicting Investment Income more Accurately
    • calc investment income from an asset model tied to liab cash flows
    • already know a lot about own portfolio - use this knowledge to predict future ii
    • ii from asset model has two parts
      • income from existing assets
      • income from future assets
  • Testing the Effect of Interest Rate Scenarios
    • can predict how cash flows change to various int rate scenarios
      • modeling assets allows testing of investmetn strategies
    • rise in int rates can cause losses for a company
      • if co subsidized the credited rate to stay competitive, reduces profit but keeps business
      • if rate not competitive, PO surrender, minimal SC, large outflow when L/T assets have depress mkt value
    • testing of int rate scenarios can have several positive effects
      • makes co more aware of significant risks it is taking
      • may change inv strategies to reduce exposure to certain risks
      • may change the products offered to reduce exposre ot certain risks
      • may limit total amt of certain kinds of business it will accept to limit aggregate risk
      • may increase certain kinds of business to better balance and diversify its risks
      • some type and levels of risk acceptable
  • Developing Int Crediting Strategies
    • mostly some capability to test int rate scenarios needed to develop and test int crediting strategies
    • need to estimate how competitor's credited rates, our credited rates and prodcut CF will vary w/ diff int rate scenarios
• Introduction to Asset Modeling
  • asset model used to project CF, mkt values, book values and otherh items for portfolio of assets
  • assuming that asset portfolio being modeled is tied to specific liab portfolio
  • assumptions
    • bonds can be purchased at time in reality
    • all bonds purchased at end of quarter, immediately after coupon payment made
    • all coupon and maturity payments at end of quarter
  • BookValue(b,cyq) = Price(b) - when bond purchased @ cyq (calyr qtr)
  • BookValue(b,cyq) = BookValue(b,cyq - 1)*(1+Qtryield(b)) - GrossCashFlow(b,cyq)
  • Gross Cash Flow includes coupons and par @ maturity
  • Book Values can also be calced as PV(future gross cash flows) @ yield rate
  • from book value, can calc net cash flows (CumCashFlow)
  • CumCashFlow(b,cyq) = GrossCashFlow(b,cyq)-[DefaultRate(b) + InvExpRate(b)]*BookValue(b,cyq-1)/4 (/4 since quarterly cf)
  • InvIncome = NetCF + delta BookValue
  • InvIncome(b,cyq) = CumCashFlow(b,cyq) + BookValue(b,cyq) - BookValue(b,cyq-1)
• Assembling Data for an Asset Model
  • Items needed (in addition to liability items)
    • prelim asset strategy
    • inventory of assets available for purchase
    • inventory of assets currently backing liab (for inforce block)
    • assumptions that describe future int rate patterns
    • strategy for dealing w/ negative CF
  • Preliminary Inv Strategy
    • need to narrow the universe of assets to consider for model
    • attributes of assets to consider (acceptable classes, quality, dur, maturity)
    • used to guide model to types and mix of assets to purchase from future positive CF
    • s/b joint effort between co's inv mgr and those responsible for liab
    • characteristics will depend on
      • co's general inv philosophy
      • A/L already on books
      • regulatory restrictions
  • Assets Available for Purchase
    • inventory of assets avail for purchase is needed
    • s/b consistent w/ prelim inv strategy
    • select a relatively small # of representative assets
    • "model assets" that reflect mix of quality ratings and assoc yields
    • do NOT mix assets w/ diff maturities - mat date greatly affects CF pattern
  • Assets Currently backing Liabs
    • Inventory of existing assests hould include all infor needed to project future asset CF, book values and mkt values
  • Future Int Rate Patterns
    • Assuming future int rates modeled one set at a time
  • Handling Netative Cash Flows
    • Two common strategies
      • borrow money
        • typically from other porduct lines w/in same co
        • need assumption as to int rate charged when borrowing is necessary
        • rate for external borrowing should reflect co's credit quality
        • borrowed funds to be repaoid at earliest opportunity from pos CF
        • S/T rates appropriate
      • selling assets
        • model must calc MV adn needs rules for which to sell first, such as
          • assets w/ largest cap gains first
          • assets w/ shortest time to mat first
          • assets held for at least 1 year first
• Asset Adequacy or Free Cash Flows
  • Asset Adequacy
    • performed on block of inforce to test adequacy of assets allocated to block
    • projection of both a/l under various int rate scenarios
    • total assets > total liab, assets adequate for scenario
    • if insufficient under many scenarios, actuary can require more assets allocated to back block
    • can be performed w/ beginning assets < or > beg reserves
  • Free Cash Flow
    • assets rebalances @ end of each period to match solvency reserves + req'd capital
    • free cash flow - fee to be uses as co chooses OR
      • req'd to be contributied to support business
  • Asset Modeling Process under Free Cash Flow Methodology
    • focus on meling assets of policy year basis
    • for model, assum CF only at BOY, middle, EOY and rebalancing only @EOY
    • at BOY and Mid-year
      • cum CF is determined
      • if cum CF > (<) 0, int rec (paid) next CF date = 1/2 years int on this cum CF
    • Beginning of Year
      • AssetsReq(t-1) = SolvRes(t-1) + ReqCap(t-1)
      • CumCashFlowBeg(t) = AssetCashFlowBeg(t) + LiabCashFlowBeg(t)
      • if CumCashFlowBeg(t) < 0
        • IntReceivedMid(t) = 0
        • IntPaidMid(t) = CumCashFlowBeg(t)*IntPaidRate(t)
      • if CumCashFlowBeg(t) > 0
        • IntReceivedMid(t) = CumCashFlowBeg(t)*IntReceivedRate(t)
        • IntPaidMid(t) = 0
    • Middle of Year
      • CumCashFlowMid(t) = CumCashFlowBeg(t) + AssetCashFlowMid(t) + LiabCashFlowMid(t) + IntReceivedMid(t) - IntPaidMid(t)
      • IntPaid[Rec'd]End(t) = CumCashFlowMid(t)*IntPaid[Rec'd]Rate(t) (and other is 0)
    • End of Year
      • CumCashFlowEnd(t) = CumCashFlowMid(t) + AssetCashFlowEnd(t) + LiabCashFlowEnd(t) + IntReceivedEnd(t) - IntPaidEnd(t)
      • AssetsEnd(t) = AssetsReq(t-1) + InvIncome(t) - AssetCashFlow(t)
    • Free Cash Flow
      • AssetsReq(t) = SolvRes(t) + ReqCap(t)
      • AssetsEnd(t) + CumCashFlowEnd(t) - FreeCashFlow(t) = AssetsReq(t)
      • FreeCashFlow(t) = SolvRest(t-1) + ReqCap(t-1) - [SolvRes(t) + ReqCap(t)] + CumCashFlowEnd(t) + InvIncome(t) - AssetCashFlow(t)
        • = CumCashFlow(t) + InvIncome(t) - AssetCashFlow(t) - SolvResIncr(t) - ReqCapIncr(t)
    • Free Cash Flow and Dist Earnings
      • FreeCashFlow(t) = LiabCashFlow(t) + InvIncome(t) + IntReceived(t) - IntPaid(t) - SolvResIncr(t) - ReqCapIncr(t)
      • new formula for dist earnings
  • Validation of Asset Model
    • compare avg int rates for each period w/ assumed yield on ne and existing assets
    • compare asset purcahses w/ resulting asset net CF taht follow
      • amts not expected to match exactly, s/b saem range
    • par value, book value and avg yield @ beg of model should match inforce portfolio
  • Asset Model Output
    • liab cash flows
    • assets purchased
    • asset cash flows
    • loans to fund cash shortfalls & repayment of prin and int
    • inv income
    • book value of assets
    • mkt value of assets
    • avg yeild on new assets purchased
    • avg yield on entire asset portfolio
    • avg dur of new assets purchased
    • avg dur of entire asset portfolio

• Overview
  • immunization - matching of assets and liabs
  • reduced financial effect of changes inint rates
  • assuming liab CF not affected by int rate changes
• Exact Matching
  • begin by matching final liab CF and working backwards to curretn time
  • cant to exact matching for very L/T (> 30 yr) liabs
  • Practical Problems w/ exact matching
    • future pos cash flows need ot purchase assets. Cant purchase future assets until then
      • need to factor future asset purchases into matching plans
      • if significant disintermediation risk, migh need to match shortest dur first
    • asset defaults or calls, matching is out of balance. more assets need to be purchased
    • if liab CF deviates significant from expectd, portfolio needs rebalancing
  • Exact matching case study - pp 756-759
• Duration Matching
  • exact matching is not usually practical
  • duration matching mor common
  • secondary use: excellent predictor of effect of small int rate changes
  • if both A/L durations matche, small change in int rates should have equal effect on A & L
  • company will have to rebalcnae occassionally to maintain matching of A/L
  • Macauly Duration
    • duration - a measure of average time of a series of CF
    • Macauly dur - weighted avg w/ PV(CF) used as weights
    • MacDuration(i) = sum(t*v^t*CashFlow(t)) / sum(v^t*CashFlow(t))
    • MacDur of a single cash flow is that cash flow's time
    • MacCur of multiple CF is wtg avg time of the CF
    • when matching A/L dur, both need to use same int rate stream - usually current rate
  • Modified Duration
    • used to estimate the effect of a small change in int rates on PV of CF
    • useful for predicting changes in PV due to int rate changes
    • mod dur is what most people mean when they say "duration"
    • PVCashFlow(i) = sum(v^t*CashFlow(t))
    • ModDuration(i) = d(PVCashFlow(i))/di / PVCashFLow(i)
      • = sum(t*v^(t+1)*CashFlow(t)) / sum(v^t*cashFlow(t))
      • = v*MacDuration(i)
      • %change in PVCashFlow(i) = -ModDuration(i)*delta(i)
  • w/ duration matching - not exact matching of CFs
  • dur matching implicitly assumes mismatches can be offest by investing/borrowing @ int rate used for dur calc
  • possible to match dur and have terrible mismatch of CF
  • Convexity
    • 2nd order deriviative of PVCashFLow(i) (modDur is 1st order)
    • Convexity(i) = sum(t*(t+1)*v^(t+2)*CashFlow(t)) / sum(v^t*CashFlow(t))
    • Mod Dur and convexity combined - more accurately calc effect of change in i on PVCashFLow(i)
    • % change in PVCashFlow(i) = -ModDuration(i)*delta(i) + 1/2*Convexity(i)*delta(i)^2
      • cannot expect 2 term formula to reproduce complexity of n cash flows
    • when matching using convexity
      • calc dur and convexity for liab CF
      • create 2 asset portfolios w/ same dur
      • blend to get convexity to match liab convexity
• Horizon Matching
  • exact matching used first few years (5-10) adn remaing CF matched using dur matching
  • as time progressed, rebalcned w/ migration of some CF to exact matching group
• Summary of A/L Matching
  • requires collaboration between actuaries (liab experts) adn investmetn dept (asset experts)
  • year-by-year CF can be significantly mismatched
    • if disintermediation is most significant risk - asset dur s/b < laib dur
    • if reinvestment risk is most significant risk - asset dur s/b > liab dur
  • discussions ingored fact that most liab CF ARE affected by int rate changes
    • policyowner optionality - PO elecing options that affect CF
      • partial w/d, pol loans, surrenders

• chapter focus on practical applications of mathematical and statistical techniques
• best estimate assumptions can usually be established w/ fair degree of confidence
  • int rate is hard to predict w/ confidence
• strategies to reduce effect of int rate unpredictability
  • conservative assumptions for i
  • offer products that adjust benefits when int rates change
  • match asset & liab cash flows
• stochastic modeling produces distribution of likely results
  • allows answers to questions such as "what is prob of ROI < 7%" or "avg roi for worst 10% of scenarios"

• Uses of Stochastic modeling
  • single product, portfolio of products, or entire company
  • increasingly used for both pricing and ongoing mgmt of A/L
  • can be applied to any variable/assumption - most commonly int rate/inv returns
• Steps Involved in Stochastic Modeling
  • select a distribution function
  • choose a random number generator
  • stochastically generate sets of variables
  • calc results for each set of rates
    • liab or prodcut related results
    • asset-related results
• Select a Distribution Function
  • should generate values that best fit the range/freq/deviation of possible outcomes
    • shoudl reproduce expected mean and variance
    • mortality - typically a binomial dist function
    • int - often normal or lognormal dist to reflect the change in int rate
  • should test to see how well it fits w/ experience over a number of years
    • parameters adjusted to improve fit
• Choose a Random Number Generator
  • used in conjunction w/ dist function to generate random values
• Stochastically Generate Sets of Variables
  • random number generator applied to dist function to create many sets of variable being modeled
  • one set of rates is however many rates are needed to run the model once
    • ex. mortality, sep rates for each cell in each period of the model
    • ex. int rates - sep yield rates for each type of asset avail for purch in each future time period (in practice - only key assets & rest are determined via reference to key rates
• Calcualte Results for Eaach Set of Int Rates
  • A/L Calcs perfomred as of deterministic model (w/ currently generated sets of rates)
  • make sure affected variables adjusted
  • ex. int rate assumptions can/will affect
    • credit rate and acct values for dynamic products
    • divs for par products
    • lapse rates
    • sales levels
    • premium levels
    • asset mkt values
    • asset calls and prepayments
  • some models will adjust for these automatically

• developed by combine dist function w/ random number generator
• general steps
  • develop cdf F(x) that reflects distribution
  • calc random number S ~ U(0,1)
  • calc x for each S F(x) = S (if continuous) F(x-1) < S <= F(x) (if discrete)
• Binomial Distribution
  • X(n) -> sum of n trials where P(x=1) = p
  • mean (mu) = np variance (sigma squared) = npq std dev (sd or sigma) = (npq)^0.5
• Normal Distribution
  • for sufficiently large values of n (book suggests minimum value of n = 30)
  • Z(n) = (X(n) - 0.5n) / 0.5*(n)^0.5 ~ N(0,1)
  • ex. generate 30 random values to calc X(30)
    • so if you need 2000 values, need 2000 * 30 = 60000 random numbers
  • then determine dist function f(x) (prob X(n) = x) ^ CDF F(x) (prob X >= x)
  • otherwise can be used to generate values of Z

• mortality fluctuations can be quite significant
• stochastic mort models can help to understand likely variability of mort results and design products or programs (such as reins) to stabilize results
• models presume all lives independent
  • not quite true, but good enough
    • multiple policies on same insured
    • disaster can simultaneously kill many insureds that work/travel together
    • common accidents on family members
    • lonely heart syndrome
• Seriatim Stochastic Modeling
  • simplest approach is model 1 policy at a time
  • perform for each policy each period
    • qd and qw for that policy that period
    • S ~ U(0,1)
    • is S <= qd policy is marked as dead (set qd = 1)
    • if not dead, S ~ U(0,1)
    • if S <= qw policy is lapsed (set qw = 1)
    • once policy terminated, s/b removed from inforce for future periods
  • essentially, each policy is its own cell
• Alternate to Stochastic Modeling
  • volatility of largest policies modeled using seriatim apporach
  • volatility of remaing policies modeled as follows
    • deterministic model to determine expected deaths each period
    • calc avg expected mort rate (q(t) for each period
    • total variance for each period approx = (#pols)*(q(t)*(1 - q(t))*(avgDB)^2
      • assumes identical policies
      • better estimate - calc variance for each cell and sum variance
      • best estimate - calc variance for each cell and sum results
    • law of large numbers - mean and variance above and normal dist allown prediction of distribution of DC
• Binomial Stochastic Modeling
  • best fits a group of independend lives w/ same mort & DV
    • often the case for a single cell
  • useful wehn seriatim approach not feasible
  • Applying the Binomial Distribution
    • allows use of 1 random number to determine outcome for n policies at once
    • how-to for 1 cell in 1 period:
      • determine assumed qd and qw and # policies in force (no) (# pols will decrease from period to period)
      • using Bin Dist, create CDF F(x) for # deaths (x) in peroid based on n pols in force
      • S ~ U(0,1)
      • if F(x-1) < s <= F(x) then x is # deaths and qd = x/n
      • using Bin Dist, create CDF F(x) for # lapses (y) in period based on n - x pols in force
      • S ~ U(0,1)
      • if F(y-1) < s <= F(y) then y is # lapses and qw = y / (n-x)
      • # pol inforce beg next period is n-x-y
  • Calculating teh Binomial Dist Function
    • apply bin dist to cell n w/ prob death = q
    • f(x) = nCx*q^x*(1-q)^(n-x) where nCx = n! / ((n-x)!*x!)
    • nCx can be gotten from Pascal's triangle
    • fratio(x) = f(x) / f(x-1)
  • fratio(x)
    • f(x) can be calculated directly (see above) but more efficient to calc iteratively
    • f(x) = f(x-1) * fratio(x) where f(0) = (1-q)^n
    • fratio(x) = q/(1-q) * (n-x+1)/x
  • Cumulative Dist Function F(x)
    • F(s) = sum(f(x)) from 0 to s

• Overview
  • more scenarios created, more credibel the results
  • # scenarios limited by speed of software/hardware
  • time for additional scenarios vs value of additional information
  • stochastic modeling of int rates best performed in aggregate
  • complexities include
    • must product yield rates for all possible future asset purchases, not just one rate for each future period
    • int rates driven by world events which can have long term effects on rates
      • can randomly generated rates adequately reflect this?
    • int rates also driven by supply/demand
  • to handle great variety of yields available on different investments, yields assumed to be some of two pieces
    • gov't yield rate from same maturity of an asset
    • spread over that yield rate (in BPS)
  • int'l standard for comparing s/t rates - LIBOR
  • In US, spread usually vs Treasuries
  • Assuming spread is fixed and unchanging for each type of asset
• Yield Curves
  • shows yield rates on one axis and time to maturity on other axis
  • normally slope upwards w/ increasing time to maturity (normal yield curve)
  • inverted yield curve - yield curves that slope downward w/ increasing time to maturity
  • in practice, yield curves defined by one S/T and one L/T rate (90 day and 10 yr) and other rates determined from these
    • interpolated rate = (1-Factor)*[90 day rate] + factor*[10 year rate]
    • sample factors
      • 90 180 1yr 2yr 3yr 5yr 7yr 10yr 20yr 30yr
      • 0 .1694 .3600 .5671 .6706 .7647 .9059 1.0000 1.0784 1.1176
• Interest Rate Scenarios
  • int rate scenario consists of one yield curve for each future period in model
  • int rates from one period to the next are highly correlated so we can't jut generate two random int rates
  • 90 day adn 10yr rate are correlated - often fall and rise in unison or partial unison
  • three approaches to handling (among many)
    • arbitrary method
    • probablistic method
    • successive ratios method
  • Arbitrary Method
    • not a stochastic model
    • involves manually creating a set of int rate scenarios in an arbitrary fashion
    • different scenarios may test effect of gradual or sudden incr/dec in int rate
    • of limited value - rarely sufficient # to be credible
    • arbitrary input -> arbitrary output
    • ex. NY 7
  • Probablistic Approach
    • assume every curve defined by level (10 yr rate) and slope (90 day/10yr)
    • using historic info, develop prob of each level changing to any other level during next period
    • probabilities arranged into grid
    • in example grid
      • sum(prob) = 1.0 for each row
      • min i = 2% and max i = 15%
      • rates equally likely to move up or down near middle of grid
      • near edges, more likely to move away from edge
    • similar grid showing probability of each slope changing to any other slope
    • randomly determine change in level and slope, still end up w/ 10yr and 90day rates that are related
    • develop CDF F(x) for each level and slope
    • can combine F(x) for current level and rand number to stochastically generate teh level for the next period's yield curve
    • can combine F(x) for current slope and another rand numberto generate slope for next period's yield curve
    • Jetton - single grid w/ yield curves and probabilities of moving from one curve to the next - only need 1 rand #
  • Successive Ratios Approach
    • assume ln of rato of successive int rates is normally distributed
      • ln(i(t+1)/i(t)) ~ N
    • don't want to apply to both 10yr adn 90 day since would end up w/ 2 ind rates
    • use one RV w/ successive ratios approacht to generate next 10 yr rate
    • combo of RV_10 adn RV_90 to generate 90 day
      • RV_10*weight_10 + RV_90*weight_90 = 90 day rate
    • weights reflect degree of correlation between 10 and 90 day
    • alternate approach uses volatility factor (VolFactor)
    • Z1,Z2 - 2 sep RV ~ N(0,1)
    • Correlation - degree of correlation between changes in i90day(t) and i10yr(t)
    • Z10yr - RV used to generate changes in i10yr(t) (reflects some correlation w/ i90day(t))
    • i90day(t+1) = i90day(t)e^(Z1-VolFactor)
    • Z10year = Z1*Correlation + Z2*(1-Correlation^2)^0.5
    • i10yr(t+1) = i10yr(t)*e^(Z10yr-VolFactor)
    • Advantages (compared to probablistic method)
      • not limited to predetermined # of int rates or yield curves
      • not necessary to research adn create large tables of probabilities
        • only need volatility factor and correlation factor
    • Disadvantages (can be corrected w/ adjustments)
      • no min/max int rate
      • no corridor...if you feel int rates will gravitate toward certain level
      • tends to product more inverted yield curves than you'd normally expect
        • Might need to bias formula towards normal curves
      • differnece between 90day and 10yr can grow to unrealistic extremes

• overview
  • Int Scenarios ->Int Rates->Product Cash Flows->Asset Cash Flows
  • four rates determined beginning of each period
    • avg rate earned on exiting assets - prior period inv income / prior period avg assets
    • int rates avail on new investments - scenario yield curve
    • int rates avail on competing products - aka Mkt Rates
    • int rates creditd to company's products being modeled - credited rate
• Modeling Interest rates
  • mkt rate - rate avail from financial alternatives
  • if co is crediting rates in line w/ mkt rates
    • surrenders, w/d s/b normal
  • if co is crediting > mkt rates - improved persistency
  • if co is crediting < mkt rates - worse persistency
    • if big difference, could see large cash outflows
  • partial w/d adn loans also affected by mkt rates (vs credited rates)
  • term generally immune to int
    • however prolonged inflation can erode value leading to lapses
  • possibly reflect non-ins product int rates
    • money mkt fund, 5yr bank CDs 10 yr govt bonds
  • new money vs portfolio rate
    • relevant mkt rate might be max(new money, portfolio)
  • probably approximated fairly well as constant spread from gov't yeild rate
• Modeling Credit Int Rates
  • function of 4 int rates
    • portfolio rate (avg net int rate earned on products backing portfolio)
    • new money rate (avg net int rate on new investments)
    • guaranteed int rate (for product)
    • mkt rate
  • int guarantees & mkt rate act as constraints on what co can credit
  • if segmentation method
    • new deposits get new money rate
    • existing deposits - net int earned on assets backing segment
  • if portfolio method - earned rate => portfolio rate (w/ some adjustment for new funds @ new money rate)
  • a product can have one or more guarantees
    • long-term guaranteed rate
    • short term current int rate guarantee
    • bailout rate
  • credited rate can't be less that LT or ST guarantees
    • can be < bailout rate if willing to waive SC
  • most co's have targeted spread they wish to earn
    • credited rate = earned rate - targeted spread
  • some cos have strategy of largest spread mkt will allow, subject to a max spread while maintaining a credited rate subject ot a min spread
  • most cos - credited rate w/in certain range of mkt rates
  • sample formula
    • Max Possible Spread (MPS) = earned rate - 90% mkt rate
    • credited rate = 90% mkt
    • if MPS > 2%, credited rate = earned rate - 2%
    • if credit rate > 110% of mkt rate, credited rate = 110% mkt rate
    • if mps < 1%, credited rate = earned rate - 1%
  • credited rate formula could reflect SC
    • existence of SC allows co to credit slightly lower rate than if no SC
• Modeling the Effect on Lapses
  • Life Ins products sole as investement vehicles generally have lapses quite sensitive to diff between mkt adn credit rates
    • especailly sensitive if product has explicit credited rate
  • study industry and company experience to develop formulas to help predict changes in lapse based on diff between mkt and credited rates
  • formula should produce no additional lapses when spread is small
    • change large and positive - lapse rates should increase
    • change large and negative - lapse rates should improve
  • sample lapse formulas
    • qw(t) = qwBasic(t)(1+0.5*(100-difference)^2) - SC% min(0.01), max(0.50)
    • qw(t) = qwbasic + 1.25*difference*3.25^|100*difference| - SC%, min(0.01), max(0.60)
  • in general, a formula should cause lapses to fall below the base rate if credited rate exceeds mkt rate
  • lapses should increase/decrease exponentially as the spread widens
  • existence of SC should lower the lapse rate
• Modeling other Product Cash Flows
  • credited rates affect dynamic CV and reserves
  • div int rate affects amt divs paid and amt applied to div options
  • partial w/d and prem persistency affected by spread for flex prem products
  • pol loan utilization increases as mkt rates increase (esp if fixed LIR)
  • expenses might inflate faster than expected
    • could model inflation = mkt rate - constant
  • anti-selection as unhealthy lives persist while healthy one lapse for more competitive products

• Steps applied to assets each period
  • asset cash flows are determined, reflecting effect of current yield curve
  • net CF determined = asset CF + product CF - dist earnings
  • if net CF > 0, new assets purchased based on inv strategy
  • if net CF < 0, model rules dictate sell assets or borrow cash
  • book and mkt values determined for all assets @ EOP
  • inv income, cap g/l determined for period
• Major Asset Classes
  • questions for each asset adn how it relates to an ins company
    • what are typical cash flows
    • what are unusual cash flows and when can you expect them (what triggers them)
      • does borrower have any rights to alter CF (by delaying or accelerating payments)
      • does co have any rights to alter cash flow (puts)
    • what expenses will co incur for mgmt/accting of each asset
    • what % of investmetn will be lost to defaults/devaluation
    • how liquid is the asset
  • Gov't Securities
    • diff between purchase price adn par is discount/premium
    • if purchased @ discount, bond's yield > coupon rate
    • if purchased @ premium, bond's yield < coupon rate
    • amount of discont/premium amortized to 0 over life of bond in a fashion that results in a constant yield to maturity
    • gov't bonds generally not callable
    • assumed default rate often 0%
    • usually lowest yielding asset
    • expenses s/b consisten w/ corp bonds
    • very liquid (most) - active mkt allows efficient trading
  • Corp Bonds
    • can have call adn put options
      • call - borrow can repay early
      • put - co can ask for early redemption
    • usually issue non-callable when rates low
    • call premium
      • penalty on borrow for early repayment
      • diff between call price and mat value
      • helps reimburse bondholder for lost int
      • call price that decreases over time ex 104%, 103, 102, 101, 100
      • private bonds have more substantial call premium
        • typically PV of all remaing int & prin payments calced using spread over yield rate on govt securities
    • model needs to make assumption as to when bond will be called
      • futher away from original yield, greater prob. @ 1%-2% change, most bonds usually called
    • puts less common
      • allows borrow to repay @ less than full maturity value
      • put option valuable for matching A/L
      • ins co can liquidate assest @ favorable prices when rates high and reinvest @ higher rates or fund outflows
    • most bonds in public mktplace
    • u/w and sale managed by one or more investment banking groups
    • privates negotiate and issued directly between borrower and lender
    • Inc Co's like privates b/c investment banker fees saved
      • privates shoudl have slightly higher yield b/c no inv banker fees
      • privates often have sinking fund provision
    • sinking fund provision clearly affects CFT timing
    • cost to borrower for call option, therefore then to have higher rate
    • put options tend to have lower rate
    • public bonds more liquid that privates (day vs week w/ higher trading costs on private)
    • diff in liquidity another reason why privates should have higher rate
    • bond have different levels of seniority. Higher seniority, less default risk, lower rate
    • BBB or higher - inv grade - majority of what ins cos purchase
    • public less expensive to manage in portfolio b/c info more readily available
  • High Yield Bonds (Junk)
    • rated lower than BBB
    • higher probability of default (5-10%) therefore higher yields to compensate for higher risk
    • historically higher yield has more than compensated for higher defaults
    • call option on high yield should have lower chance of being exercised
      • like mortality anti-selection
  • Commercial Mortgage
    • large loans on commercial real estate (retail/office buildings)
    • normally prin & int over 20 years, due @ 10 (10 year ballon)
    • borrow usually pays origination fees
    • usually contain prepayment provision
      • prepayment penalties usually modest
    • default risk usually highly correlated by geographic area
    • not as risky as junk, but don't want too high a concentration
    • fairly illiquid w/ no active mkt
      • can usually sell a group of comm mort in about a month
    • high asset monitoring costs
  • Residential Mortgages
    • loans on residential real estate - typically 50-80% of mkt value of real estate
    • monthly payments of int and prin
    • most 15 adn 30 year
    • fixed of variable int rates
    • mortgage may be purchased at either premium or discount
      • amortized over life of mortgage, altering yield somewhat
    • can be prepaid, usually w/o penalty
      • if penalty exists, only first couple years
    • level of prepayments based on multiple factors
      • as int rates drop, more refinancing
    • default risk
      • usually related to unemployment, dis, death
      • increases during recession (like junk and comm mortgages)
    • fairly illiquid w/ no active market
  • Collateralized Mortgage Obligations (CMOs)
    • mortgage specialists assemble pools of thousands of indiv mortgages, then sell slices to investors
    • securitization - creation of a new financial security that is backed by underlying cash flows
    • by purchasing a slice of thousands of geographicly diverserve mortgages, buy can diversify risk
    • tranche - slice of CMO
      • payment and interest of each tranche varys depending on underlying cash flow
      • each int paymetn dependent on underlying morgage prin outstanding
      • each tranche receives its principle (subject to default) but amt of int rec'd depends on prepayment speed
      • shorter tranches generally receive most of principle repayments first
    • modeling is difficult b/c sensitivity of prepayments to change in i
    • PAC (planned amortization class) - specialty tranche developed to address stability issues for investors
      • PAC investure assured of getting fixed, pre-scheduled payments over speciifed period over a wide range of prepayment scenarios
      • more volatile tranches created to absorb flucuations
      • PAC has lower yield therefore other tranches can have higher yield for higher uncertainty
    • many CMOs backed by gov't securities therefore no defaults and AAA rating
    • CMOs actively traded and liquid (some volatile tranches may be difficult to sell)
    • considered investment grade
  • Asset-Backed Securities (ABS)
    • consumer/corp debt - ex. credit card balances, auto loans, home equity loans, bank loans, commercial mortgages
    • similar to CMOs
    • some unique regulatory/acctg issues make these not as popular w/ ins cos
    • CBO - collateralized bond obligation - corp bonds
  • Real Estate
    • most produce rental income - modest and uncertain compared to bonds and mortgages
    • cash outflows req'd to maintain property
    • largest cash flow is from sale of property
    • sizable portion of return from apprectiate in property value
      • some depreciate
    • perhaps most illiquid asset
    • poor match for most ins liab (modest/variable CF)
      • makes sense when matched against very long-term liab or portion of co's capital
  • Common Stock
    • trend toward smaller divs (as % of stock price)
    • rarely purchased for ongoing cash flows
    • appreciation in price is main attraction
    • prices highly variable
    • very liquid - related to # shares outstanding (more shares, more liquid)
    • historically 9-11% total return over 20-year periods
    • poor match for most liab (low CF, volatility in price, acctg treatment)
    • makes sense when matched against very long-term liab or portion of co's capital
    • liquidity could be welcome addition
  • Preferred Stock
    • similar to bond w/ no maturity date
    • junior to all bonds
    • some have options to convert to common stock
      • potentially valuable is stock price increases
    • tax treatment of Pref Stock divs different from bond int
    • fairly liquid, but ont as liquid as CS or bonds
    • prices behave much like prices for 30+ year bonds
    • if yield/quality acceptable, non-callable PS could make excellent match for longest LT liab, esp > longest bond mat avail
  • Policy Loans
    • if fixed int rate, utilization increases when PO can earn higher rate elsewhere
      • some co's reduce credited rate on portion of value loaned
    • par products make adjustments for loaned policies as well
    • if variable rate, utilization will be more stable
    • an increase in int rates can cause
      • increase in surrenders (which repays policy loans)
      • increase in policy loan activity
• Summary of Asset Cash Flows
  • Positive Asset cash flows
    • sales of any asset type
    • bonds
      • coupon payments
      • calls (mat val + call prem)
      • puts (mat val - put discount)
      • sinkng fund payments
      • maturity payments
    • mort/cmo/abs
      • regular payments of prin & int
      • prepayments of prin and any prepayment penalties
      • maturity payments
    • real estate rental income
    • CS & PS dividends
    • policy loans
      • int payments
      • prin repayments
  • Negative Asset cash flows
    • investment expenses for all types, incl real estate maint
    • improvements to real estate
    • nwe/add'l policy loans
    • asset defaults
• Stochastic Modeling of Asset Cash Flows
  • overview
    • extrememly difficult undertaking
    • basic groupings
      • sales of assets
      • prescheduled CF
      • premature CF
      • asset defaults
    • prescheduled can be easily reflected once others addressed
  • Sales of Assets
    • many models assume assets held until they mature/prematurely repaind
      • often @ odds w/ actual mgmt sime portfolios often actively managed
    • best to reflect reality
      • if activley managed portfolio, strategy s/b discussed & reflected in model
  • Premature CF
    • bond calls driven almost entirely by int rates
    • to model bond calls, build grid of bond call rates that vary by change in i and bond quality rating
    • bond puts
      • controlled by insurer
      • establish some parameters for exercising puts
      • ex. if put price >10% above mkt value or neg CF & put price > mkt value
    • extra sinking fund payments - modeled similarly to calls
    • mortgage prepayments - similar to calls
    • residential mortgages - add'l level of prepayments unrelated to delta i (relocations, bigger homes, etc)
    • CMO/ABS prepayments - brute force approach - model all tranches to figure out what your trache will do
      • recommended alt - table of prepayment rates that vary w/ delta i
  • Default Assumptions
    • CF interrupted on first default
      • many times, assets in default are rehabbed and missed payments made up
      • other times, asset sold @ reduced price
        • reduction in price & missed payments is true cost of default
    • simplest approach is treat defaults as perm loss of % of asset
      • ex. if 0.4% annual default, carried in book @ 99.6%, 99.2%, etc
        • CF reduced accordingly
    • economic downturn will incr default rates for many asset types
      • if possible, vary default rates w/ economic activity
• Purchasing New Assets
  • inventory of possible new assets part of input into model
  • need to purchase from this inventory, if positive net cash flows
  • ways to apply co's inv strategy
    • input data may specify % of new assets to be invested in various classes of various quality and maturity
    • input data may specify dist of new assets by asset class & quality and let model determine maturity to better match A/L CF
  • might have different strategies for different LOB
• Covering Cash Shortfalls
  • what to do when net CF is negative - borrow $ or sell assets
    • sell assets closest to mat date - MV least affected by delta i
    • if investors don't care about unrealized g/l, sell assets w/ offsetting cap g/l
    • sell assets that help co better match A/L
      • ex. if assets longer than liab, sell LT assets
      • modify strategy to min net cap g/l
• Calculation of Investment Results
  • Book Values
    • for many assets - price originally paid
    • bonds, mort, cmo, abs - starts equal to price paid
    • bonds: book = mat val + unamortized prem/discount
    • mort/cmo/abs: book = loan priinciple + unamortized delta(price paid/principle)
  • Capital G/L
    • delta price sold and book value @ time of sale
    • defaults recorded as capital losses
  • Investment Income
    • includes capital g/l
    • InvIncome = Net Asset CF + increase in book value during period
    • if new assets included in net asset CF as negative, will be included in delta book as positive
      • no effect if purchased @ EOY
      • 6 mo growth if mid-year purchase

• # of scenarios depends on variablity of results
  • depends on speed of modeling software and complexity of model being tested
• once all scenarios tested, results arranged sequentially, summarized by percentile adn sometimes gruoped to see range of possible results

• fin goals vary widely from co to co in ins industry
• focus on ROE, embedded value, consistent growth in earnings & revenues, total return to stockholders, total return to PO
• factors influencing choice
  • type of co
  • co tradition
  • company strengths and weaknesses
  • past co results
  • competition
  • regulation
  • fin mkts
  • personalities and beliefs of senior mgmt
• need to activley monitor and manage finances in 3 braod areas
  • risk management
  • earnings management
  • capital management
• in most cases - risk mgmt motivated by desire to stabilize earnings
  • protects company's solvency

• overview
  • Informational Tools - Financial analyasis and modeling
  • Risk transfer options - reinsurance adn acq of business
• Finanacial Analysis
  • worthwhile analysis provides info that leasd to decisions
    • I/S & B/S results (broke down by LOB or finer)
    • mortality and lapse studies
    • inv results, including net int rates and default costs, inv expenses, cap g/l by asset class and segment
    • distribution fo sales by product, risk class, gender, etc
    • relevant unit costs for vaious levels fo decisions
  • by reviewing past, learn from mistakes, see where doing good and adjust accordingly
• Modeling
  • ability to project future financial results
  • results need to be at least as detailed as various summaries avail from fin analysis
  • useful for testing effect of various decisions on future earnings and other results
  • can be used to produce PV of future results
  • Embedded Value(begyr) = sum(DistEarn_tot(calyr)*1+i)^(begyr-calyr))
  • allows determination of which products/pkts/other factors contributing/detracting from goals
  • can be used to roughly estimate costs and potential value of adding new markets, new dist systems, new products
• Combined Financial Analysis and Modeling
  • connect teh past and future - giving more complete view
  • combined results can help w/ questions such as
    • to stop offering certain products
    • exit certain markets
    • sell or close down LOB
    • keep co independent or seek affiliation via merger/aquisition/being acquired
  • can calc LT performacne measures such as ROI or wtg avg ROE
  • solve 0=sum(DistEarn_tot(calyr)(1+ROI)^(-calyr)) across all years for ROI
    • remember: simple ROI can be misleading, esp if multiple sign changes
• Reinsurance
  • possibly most flexible tool for managing financial position
  • in addition to transferring risk, it can shift earnings, capital, revenue, benefits, expenses, assets adn liab from one co to another
  • Effect on Stability of Earnings
    • can be used to stabilize earnings - more than any other tool
    • can be used ot offest virtually every kind of risk
    • usually used to stabilize mortality risk
  • Effect on Pattern of Earnings
    • pattern of YRT prem rates often doesn't match pattern of exp mort
    • difference in patterns can affect incidence of earnings by yera
    • varying term adn features allow possibility of many diff fin objectives
    • when risk is transferred, req'd capital also transferred
    • pattern of earnings can be shifted or left alone
    • can be designed to have benef effect on taxes,esp when unused tax losses about to expire
    • usually affects timing of solvency earnings adn taxable earnings (including current period earnings)
    • effect of reins on expected stockholder earnings usually spread over dur of agreement
    • sometimes designed specifically to ahve desired effect on solvency or taxable earnings
  • Reinsurance as Capital
    • can be used to obtain financing more quickly, often cheaper, compared to debt/equity
    • since risk transferred, also financies strain of new business and lowers ceding co's capital req
    • allows co to write higher levels of NB if sales take off
    • can assume reins to put excess capital/dis earnings to work
    • may be possible to generate tax losses
    • every reins trx has same effect on capital of both cos
    • possible to construct reins to accomplish several targets, such as
      • transfer of targeted risks
      • transfer of a targeted amt of cash (including none)
      • targeted increase/decrease in
        • solvency earnings
        • solvency capital
        • assets
        • liab
        • req'd capital
    • not only increase co's capital, but decreases need for capital by reducing risk and req'd capital
    • some countries limite reins severely
    • reins as capital can behave more like equity or deby
      • if amoutn of reief is large in relation to future earnings, like equity, small, more like debt
  • Reinsurance Leverage
    • can be used to leverage a co's returns

• Overview
  • most complex & difficult way to affect co's fin results
  • sometimes sell blocks of business to raise capital
    • usually dispose because does not have econ of scale, not a stategic fit, low rate of return
  • buy blocks to build econ of scale, add value by cutting expenses, put idle capital to work, grow co for benefit of owners
  • excess capital amoung life ins often leads to fierce price competition for acquisitions
• Assumption Reinsurance and Indemnity Reins
  • acq or sale of blick of business usually accomplished by special form of reins
  • reins not needed for sale of entire co
  • Assumption Reinsurance - company that issued policies is removed from liab after block of business sold
    • some jurisdictions require PO approval for assumption reins
      • in those cases, use indemnity reins w/ transfer of admin
    • no right to recapture for any reason
  • Indemnity Reins - company that issued policies is NOT removed from liab stream
    • seller relys on reinsurer to reimburse for all benefits paid
    • admin typically transferred to buyer
    • buyer handles all transactions
    • seller still has to reflect business on books (w/ 100% offset)
    • accomplishes most of toals of assumption
      • seller receives fair value and no longer has to admin pols
      • however, since still on books, ultimately liable if something happens to reinsurer
      • this risk is usually better than deling w/ requirements that might be imposed in assumption situation
      • seller has no right to recapture, except for breach
• Prerequisites for an Acquisition
  • number of conditions
    • buyer must have access to capital necessary to complete acq
    • must be likely to improve buyer's earnings
      • "buyers curse" - historically, results of most acq significantly worse than orig expectations
    • buyer must have resources to complete acq
      • need staff capable of handling integration from start to finish
  • differences in business practice can force complex choices
  • most difficult aspect -> people
    • if acq driven by expense saving from combining operations -> downsizing
  • better integration strategy is very few changes immediately after acq
    • gradually institure changes that buidl on strengths and bring orgs closer together
• Prerequisites for a Sale
  • seller must have use for capital raised by sale
  • sale must be likely to improve seller's earnings
  • seller s/b aware of pirce currently avail for business (might not be right time to sell)
  • what effect will sale have on remaining staff if only part of co sold
• Determining the Purchase Value of an Inforce Block
  • when block of inforce purchased, need to agree on two things
    • what amount of liab will buyer assume? Typically solvency reserve of block
    • what amount of assets will seller transfer to buyer in order for buyer to assume liab
  • Typically assets transferred < liab transferred
  • Purchase Value = liab transferred less assets transferred
    • = SolvRes(0) - Assets(0) wehre time 0 is purchase date
  • Assets(0) most difficult part of negotiations
    • typically begin w/ EV(0) using buyer's desired rate of return
    • = SolvRes(0) + ReqCap(0) - EV(0)
  • Purchase value typically tax deductible, but still may be tax impact @ time 0
    • Tax(0) = (SolvRes(0) - TaxRes(0) - PurchaseValue - TransCosts)*EarnTaxRate
    • other items might affect Tax(0) and need to be taken into account
  • Assets(0) = SolvRes(0) + ReqCap(0) + Tax(0) + TransCosts - EV(0)
  • PurchaseValue = EV(0) - Tax(0) - TransCosts - ReqCap(0)
  • EV(0) = PurchaseValue + Tax(0) + TransCosts + ReqCap(0) (rearranging prev formula)
• New Business and Goodwill
  • closed block = no new business
  • if block sold still has NB coming on (and sale assumes will continue), results in intangible asset on B/S
  • often reflected only in stockholder acctg
  • Goodwill
    • value of future new business
    • a risky asset for stockholder accounting
    • value of intellectual capital, reputation, brand name, and other intangible assets
    • for stockholder acctg, balancing item to force assets = liab @ purchase
  • Amortization of goodwill reduces earnings
    • straightline over X years (10-40 typically)
  • some countries allow goodwill to be expensed immediately
  • can have major effect on acq, depending on how quickly amortized adn tax deductibility
  • no simple formula for determing purchase value for an ongoing business
  • usually only include 3-5 year NB in purchase value b/c of risk and uncertainty
• Purchase Price and Purchase Value
  • no consistent def of purchase price
  • press release version is typically some function of public acctg stds used by cos involved
  • purchase value defined b/c of lack of definition
  • other considerations - stock co
    • effect of acq on stockholder EPS & ROE
    • if dilutive for more than S/T, might not be attractive
    • wtd avg ROE < target b/c of acq might not be attractive
• Earnings Mgmt
  • Act or sales of business can help manage earnings
    • can sell loss-producing business. Loss now, but avoids future losses
    • can buy business - usually moves it earnings up a notch (or more depending on size)
    • strategy of growth primarily through acquisition
      • need confidence and backing of fin mkts to raise capital necessary
      • or convince sellers to accept buyer's stock

• Overview
  • understanding, balancing, and controlling the risks inherent in a LIC
• Market Risk
  • Int Rate Risk Asset Valn Risk SubOptimal asset allocation
  • Mkt Fluctuation Risk Spread widening risk currency fluctuation risk
  • Interest Rate Risk
    • discussed previously
    • fin derivatives can be purchased as int rate hedges
    • even matched A/L can have risks b/c of acctg quirks
      • some assets marked to mkt and liab not
    • ways to control risk
      • encourage saels of products w/ MVA, incl variable products
      • limit sales of products w/o MVA
      • hold extra capital to be able to withstand int rate fluctuations
      • work w/ regulators & acctg bodies to bring acctg fo rliab in line w/ acctg for assets
  • Market Fluctuation Risk
    • MV of volative assets (CS & Real Estate) subject to considerable fluctuations over time
    • 3 main strategies for managing risk of loss do to a fall in mkt values
      • use volatile assets mainly to back products w/ MVA (incl variable products)
      • otherwise limit volatile assets to small percentage of overall assets
      • hold extra capital to be able to withstand mkt fluctuations
  • Asset Valuation Risk
    • risk of overly agreesive valuation of assets
    • difficult to determine MV is not an active mkt for a particular type of asset
    • sometimes person who purchased asset is same person who asked to provide MV
      • conflict of interest
    • if significant portoin of co's capital in affiliated co, need to take extra precautions to ensure unbiased estimate
    • undervaluing assets can also be a problem
    • step to reduce asset valuation risk
      • majority of funds in assets w/ readily available & verifiable MV (such as publicly traded stocks and bonds)
      • ensure controls exist so that those determining MV of assets do so independently
        • independent audits should reinforce these controls
        • for large inv in an affiliate, consider IPO to sell parot of the affiliate to public and establish an independent mkt value for it
  • Spread Widening Risk
    • an asset class can fall out of favor, resulting in spread widening
    • spread widening is a function of supply and demand
    • strategies to control spread widening risk
      • invest mainly in assets w/ small risk of spread widening - high quality, heavily traded, widely held securities
      • use assets w/ large spread-widening risk mainly w/ products that have MVA (including variable products)
      • otherwise limit to small % of total assets
      • hold extra capital to be able to withstand effect of spread widening
  • SubOptimal Asset Allocation
    • level of asset risk s/b tied to capital position
    • extra capital -> take on more risk
    • is enough risk being taken given the co's capital position?
  • Currency Risk Fluctuation
    • balance sheet risk and i/s risk
      • B/S risk - a/l significantly out of balance by currency
        • currency change could reduce co's capital
        • managed by balancing a/l by currency
      • I/S risk - income, benefits & expenses significantly out of balnace by currency
        • currency change could reduce co's net income
    • buy currency hedges, but not common
    • normal fluctuations in earnings often > fluctuations due to currency changes
      • might not make sense to stabilize relatively small currency risk
• Credit Risk
  • overview
    • several categories (first 3 asset related)
      • asset default risk
      • concentration risk
      • risk of inadequate spreads
      • counterparty risk
  • Asset Default Risk
    • excessive asset defaults that may result from prolonged poor economic conditions or poor asset selection
    • managed by
      • share risk of default w/ PO via MVA and variable products
      • invest in mainly inv grade assets
      • limit investments that are below inv grade to a small % of assets
      • hold extra capital to withstand effect of excessive asset defaults
  • Concentration Risk
    • risk associate w/ large protion of co's investments concentrated in a particular issuer/sector/industry/part of country/part of world
    • can be controlled by adopting (and following) a strick policy of diversification of risk
  • Risk of Inadedquate Spreads
    • credit-realted spreads may not adequately compensate investor for credit risk assumed
    • risk is smaller where reliable info is available over a long period
    • controlled by limiting % of assets invested in newer/less familiar issuers/sectors/countries/classes of assets
  • Counterparty Risk
    • risk that outerh parties not able to fulfil their obligations
    • controlled by only dealing w/ high-quality business partners or diversify by spreading risk w/ multiple business partners
    • for reinsurance, YRT and Coins Term largely "paygo" so minimal risk
      • larger risks can be reduced by placing assets in trust or securing letters of credit
• Liquidity Risk
  • overview
    • risk of not being able to meet the cash flow obligations on time
    • types of liquidity risk
      • "run on the bank"
      • holding co
      • risk of excessive liquidity
  • "Run on the Bank" Risk
    • risk that ratings dwongrade or other adverse publicity could cause many of co's PO to simultaneously demand cash from the co
    • strategies for dealing w/ run-on-the-bank risk
      • give co an option to delay payments when designing ins contracts
      • avoid "hot money" products - products sold to those who quickly move their money when conditions change
      • maintain some % of co's portfolio in highly liquid asses/gov't securities/st investments/cs)
      • establish credit facilities that allow co to raise cash immediately in a time of need
  • Holding Company Liquidity Risk
    • applies to LIC owned by holding co
    • LIC may have adequate liquidity, but holding parent may not
    • holding co needs $ to pay divs, int on debt, cover expenses, etc
    • holding co only regular source for additional cash if divs from subs
    • if subs growing and need add'l capital - could be problematic
    • regs often limit amt of divs that can be paid by LIC (to protect solvency)
    • other source for holding co $ is capital mkts
    • holding co liquidity risk best managed by planning well ahead
  • Risk of Excessive Liquidity
    • could maintain too much liquid assets and not get enough yield
    • determine optimal level of liquidity
    • credit may provide liquidity protection cheaper (compared to loss of yield w/ liquid securities)
• Pricing Risk
  • Mortality/Morbidity/Longevity/Pricing Assumption/Liability option
  • Mortality Risk
    • RBC factors for mort risk based on 1918-1919 flu epidemic
    • advances in medical science, but partially offset by potential to spread quickly (air travel and increased mobility)
    • natural disasters
    • man-made disasters
    • selective lapsation - genetic testing
    • should take measures to protect against - w/in reason
      • hold extra capital
      • reinsurance - regular and cat
  • Morbidity Risk
    • primary cause of unexpectly hig morbidity cost - ability of insured to outwit ins co
    • us economy of 80/90s let to situation where more attractive to be disabled than working
      • liberal u/w & loopholes in definition of dis allowed relatively healthy insureds to make legitimate claims against policy
    • controlled through
      • careful u/w
      • diligent handling of claims
      • clear and verifiable benefit provisions
      • designing benefits that encourage beneficial behaviour (partial dis benefit)
  • Longevity Risk
    • annuitiants living longer than expected (reverse mortality risk)
    • little can be done to cotrol risk
      • allow fo rgreater mort improvement when pricing
      • attractive priced reins hard to find - reinsurers have similar concerns
  • Pricing Assumption Risk
    • danger pricing assumptions wrong
      • new mkts/new products/new u/w stds/new dist systems
      • inadequate experience to base assumptions
    • unlikely to happen when pricing assumptions based on credible experience
    • sometimes price below cost in anticipation of being able to reduce cost
    • good ways to reduce pricing risk
      • reinsure business that has worrisome levels of pricing risk
      • work w/ pricing experts (consultants/reinsurers) to develpo assumptions that reflect latest information/techniques available
  • Liability Option Risk
    • improperly priced options given to PO
      • perhaps greatest shortcoming in life ins pricing
    • cost of most options is never quantified and never explicitly reflected in pricing
    • to manage risk
      • greater level of awareness and cost of such options
      • use of reinsurance
      • consciously avoid too large a concentration of option risk
    • manage concetration of risk similar to how done for assets

• overview
  • decisions and actions a co can take to influence FUTURE earnings (usually too late to affect current period earnings)
  • two common goals
    • grow earnings over time - usually @ targeted growth rate
    • minimize unexpected fluctuations in earnings
• Product Management
  • managine inforce products and design adn intro of new products to help co better meet fin goal
  • essential for good earnings mgmt
  • limited ability to adjust inforce products to achieve fin goal and manage earnings
    • divs/non-guar prem/credited int rates/COI rates all changeable
    • considerations when making these adjustments
      • delivery on promises
      • equity among policyowners
      • effect on persistency
      • regulatory restrictions
  • pricing of new prducts - most imprtant tool to drive future earnings
    • increase profit margins on new products
    • introduce productw w/ features that reduce risk, increase earnings, improve competitiveness and sales levels OR reduce capital needs
• Asset Management
  • Inv strategies can be shifted
    • Avg yields and earnings increase by shifting to riskier (or less liquid) investments
      • if in position to easily handle greater risk, wise to improve yields
    • could focus on reducing volatility of earnings
      • usually not possible to both increase yield and decrease volatility
    • A/L matching strongly encouraged
    • reasons why mismatching occurs
      • liab CF too unpredictable to match, except over short horizon
      • A/L purposely mismatched to improve avg yields adn expected earnings
        • best handled by co that is over-capitalized and consciously using excess capital to support mismatching
    • LT yields can be improved by increasing proportion of assets in stocks/realestate
      • need strong capital position to absorb up/downs of mkt
      • disadvantage: treatment of cap gains by stock mkts essentially ignored by stock mkts b/c can use to artificially inflate earning in a given year
    • if co & stock mkts focused primarily on operating income (excl g/l)
      • some volatility acceptable if confined to capital g/l
• Expense Management
  • lower expenses generally means higher profits
  • quality and friendliness sometimes matter more than price or efficiency
  • crucial to understand what matters to customers and dist system
    • look @ not only cost, but what it buys you in customer satisfaction of agent loyalty
  • some worthless activities can be ingrained into organization adn therefore hard to recognize and eliminate
  • Major Expense Reductions
    • common techniques
      • across-the-board cut - not always a good thing since some areas need to expand, not shrink
      • "surgical incissions" - intelligently reduce expenses in areas that most need reductions
      • corp raider perspective - look at company from view of corp raider - "slash & burn" areas to shave expenses and boost profits
        • ask what a corp raider would do, then do it yourself
      • start-up perspective - look @ co from POV of new, start-up co
  • Minor Expense Reductions
    • analyze jobs throughout co & derive value that each job adds to co
      • might also identify structural problems such as too many layers of mgmt & not enough workers
    • pursue outsourcing - allows a co to focus on what it does best
      • if someone else can do it cheaper, let them
    • reengineer processes - involves redesigning or automating processes to improve service or reduce costs
    • restructure or reorganize all/part o fthe company so various units wrok together more effectively
    • identify ways that company culture can be shifted to improve collaboration, communication, decision making, initiative, creativity, retention of staff, etc
  • Allocation of Corp Expenses
    • expenses that directly or indirecty relate to a product line s/b allocated accordingly
    • expenses not related to anything but total co (corp expenses) should not be allocated
    • create a "corp" LOB
    • possible def of corp expenses - those that would be eliminated or replaced if company merged into larger organization
    • allocating corp exp to LOB may disguise true contibution of each LOB
  • Legacy Systems
    • outdated, patched-together systems used for u/w, issue, billing, etc
    • conversion is hugely difficult, maint is increasingly complex and expensive
    • solving this problem has huge savings potential
    • possible solution
      • modern system for all NB
      • bridge over existing as needed
      • eventually only the most difficult products left on legacy system
      • "incentive" replacement to PO to get policies off books or put forth the effort to get the final policies moved

• overview
  • maintaining the proper amounts and types of capital needed to efficiently and safely run the company
• Determining the Proper Amount of Capital
  • several perspectives
    • insurance regulations
      • specify min amt capital req'd to remain solvent and operate independently
      • co's strive to maintain capital well in excess of min reg to handle fluctuations
    • rating agencies
      • rate financial strength/claims paying ability of inc cos
      • use req'd capital formulas similar to regulators
      • more likely to adjust req'd capital to reflect greater familiarity w/ bus of each co
    • company
      • internal point of view as to how much is proper
      • in line w/ primary competitors
  • formulas based on historical events and designed to provide enough capital to survive all but most unusual/extreme events
• Determining the Proper Capital Structure
  • debt/equity/reinsurance - options more limited for mutuals
  • Corporate Structure
    • most common - stand-alone life insurer w/ no parent and no subs
      • can issue stock to raise equity capital
      • cannot make effective use of deb (ins regs - debt is not capital for solvency purposes, but liability)
    • many ins cos have parent holding co - to make effective use of debt
    • parent co issues debt and uses proceeds to make captial contribution to ins sub (debt from parent becomes equity to ins co)
    • single ins co w/ all ins operations creates some capital efficiencies
      • same capital can be used to support mult ins businesses, often w/ complementary risks
    • common for large corp to have many holding cos and many ins cos
      • add'l holding cos oftern useful for capital and tax reasons
    • corp structure partially driven by careful planning and partially by historical events, such as past acq
  • Equity
    • usually largest component of capital
    • owner's capital contributions & retained earnings of co
    • capital w/ highest risk, therefore investors demand the highest return on equity capital
    • PS & CS do not have to be repaid
      • no scheduled maturity date adn no repayment of prin
      • normally pay divs
    • CS divs must be discontinued before PS divs are cut
    • cutting of divs viewed by mkts as sign of poor performance/weakness/distress
  • Debt
    • mainly used by stock cos
    • holding co needed to make debt useful to ins co
    • viewed as low-risk capital (for co's w/ good fin ratings)
    • often, int paid on debt is tax deductible to the borrower
    • since relatively safe, investors settle for much lower rate of return on debt capital
    • cost of debt (usually) only slightly higher than yield avail on new investments of similar quality and maturity
    • most appropriate for supporting low-risk capital needs
    • should structure maturity of various debt offerings to match release of excess reserves adn capital
    • s/b structured in conjunction w/ A/L management since debt is another form of liab
    • bond debt most commoon
    • bank debt - usually S/T @ s/t floating int rate
    • if co fails to make int or prin payments on time, faces bankruptcy
    • cost of borrowing increases as % of capital in form of debt increases
    • rating agencies will lower ratings if it adds too much debt
    • investors will criticize if co doesn't make sufficient use of debt to leverage returns
    • WACC - weighted avg cost of capital
      • = % of capital in equity * desired return on equity + % of capital in debt * after-tax cost of debt
    • if co has long range target ratio of debt adn equity, WACC can serve as basis for hurdle rate
  • Combinations of Debt and Equity
    • aka mezzanine financing
    • convertible bonds and surplus notes - types of mazzanine fin used by ins cos
    • convertible bond - features of both debt and equity
      • similar to regular bond except
        • much lower rate of int
        • convertible to CS @ price that s/b attractive in a few years
      • rating agencies might view as more equity than debt depending on how attractive conversion option is
    • surplus notes - function like bonds, except coupon and mat payments
      • subject to ongoing approval by ins regulators
      • if regulators prevent payment, co is NOT in default and lenders can take no action
      • treated as equity for solvency purposes
      • rating agencies view as more debt than equity since likely to be repaid
  • Reinsurance
    • favorable attributes of using reins as capital
      • transfer of risk as well as capital
      • reduction in need for outside capital
      • access to capital as needed, vs prematurely raising idle capital in the form of equity or debt
• Methods of Raising Capital
  • Sources of Capital for Mutual Cos
    • if formed by original group of PO, these PO would provide capital needed to start co
    • if formed by mutualization of stock co, capital remaining after stockholder buyout is starting capital
    • once capitalized, no ability to raise add'l equity except retained earnings
    • two levers to keep actual capital in line w/ req'd capital
      • carefully manage growth so capital needs do not outstrip growth in capital
      • manage divs to PO so existing PO provide add'l cap needed to finance new PO
  • Sources of Capital for all Cos
    • reinsurance (in most jurisdictions)
      • amounts and timing of provided captial can be dovetailed to closely match the business needs
      • surplus notes (where regs permit)
      • sell all or part of one of its businesses to raise capital
        • moving a successful business to a sub and selling a piece of it to the public particularly effective way to raise capital
        • when a co sells all or part of one of its businesses, may move from too little capital to too much and not know what to do with it
          • need to consider where/how to deploy raised capital
          • if too much, may be other ways to structure sale
  • Sources of Capital for Stock Cos
    • in addition to prev choices, fin mkts to raise debt and equity capital
    • debt
      • easier to raise
      • greater a co's fin strength, lower the int rate
      • lareg amt of debt usually financed by selling bonds to public
      • moderate amts - sometimes sold privately
      • s/t adn smaller amounts - usually provided by bank debt
      • bank debt - couple days to arrange
      • public bonds - a couple months for req'd documentation and approvals
      • private - quicker
    • equity
      • can be problematic
      • existing stockholders & new investors have opposite points of view
      • existing stockholders - dilutes their ownership
      • unless capital rec'd from add'l shares can be immediately deployed to earn same rate as existing capital, offering will be dilutive to EPS
        • if permanently dilutive - offering was a stupid idea
      • new investors - need to be drawn to offering
        • must regard co and/or stock price as attractive
      • IPO - takes approx 6 mos
        • subsequent offerings - much faster b/c most of req'd info already publicly reported
• Methods of Deploying Excess Capital
  • most obvious and most ignored option - distribute to owners
  • Distributing Excess Capital to Owners
    • special dividend if stock co or increase div rate to pay out over longer period
    • buy back shares of stock (if publicly traded)
      • tends to raise price of shares since remaining shares own greater portion of co
      • more tax-efficient than dividends depending on tax laws
    • enhance PO benefits (if Mutual) - increase divs, enhance crediting rates, lower COI
  • Deploying Excess Capital into Current Operations
    • examine current operations to see where extra capital could do some good while providing adequate return on that capital
      • if capital has been main pricing constraint, more capital-intensive be developed or existing products repriced
      • expand distribution capabilities
      • significant projects to improve productivity or service capabilities
    • when raised through debt/equity offering, often more capital than it can immediately use
      • makes sense to deploy excess capital through a few large/ST transactions
  • Deploying Excess Capital into New Operations
    • opportunity to start up new LOB, enter new mkt, build new dist system or pursue acquisition
    • must ultimately change or face obsolescence
• Internal Capital Management
  • overview
    • Company must allocate capital to each business to properly measure performance
    • assets backing liab & capital of each business must be allocated
      • allows inv income to be calced for each business
    • two common methods for allocating capital: historical and req'd capital methods
  • Historical Method
    • tracks results for a business from inception, accumulating actual cash flows and ignoring capital reqs
      • pro:
        • tracks inception-to-date contribution of each business
        • current results can be viewed in context of historical capital contributions
      • con:
        • ignores reality by ignoring req'd capital, since buiness must maintain some req'd capital
        • understates earnings when accum earnings < req'd capital
        • overstates earnings when accum earnings > req'd capital
        • ROE grossly misstated (both earnings and equity distorted)
        • requires co to keep accurate records of capital contributions to and distributions from each buinsess
    • can lead to significant misunderstandings and mistakes
  • Req'd Capital Method
    • allocates amt of capital req'd to support a business, ignoring past results
    • actual earnigs calced consistent w/ dist earnings
    • results for young and old business NOT distorted by historical results
    • can be allocated by region, etc
    • Authors believe req'd capital is THE RIGHT METHOD for measurinng current performance
      • however, many co still use historical method
    • if no clearly defined std for req'd capital, may be hard to apply
  • Value At Risk
    • two components of req'd capital (RC)
      • portion truly at risk
      • portion req'd to satisfy redundant req'd reserves/excess cap req
    • value at risk - method of allocating capital that reflects both components
    • two-tier approach for each business
      • high-risk req'd capital - amt of capital necessary to withstand adverse experience (amt to withstand 99% of 1 yr fluctuations)
      • low-risk req'd capital - amt needed to maintain fin ratings or attain desired level of fin strength
      • third-tier - not allocated - overall excess (or shortage) of capital
    • ideally Tier 1 s/b backed by equity adn Tier 2 by debt
      • in reality, debt req'd for Tier 2 would not be acceptable
    • if Tier 3 < 0, capital s/b raised
    • Using VAR to Allocate Cost of Capital
      • calc WACC
      • allocate asses backing reserves & Tier 1 req'd capital to LOB
      • retain assets backing Tier 2 in unallocated corp segement
        • allocate a charge for Tier 2 req'd capital to LOB
      • retain assets backing tier 3 in sep unallocated segment
        • allocate NO charge since excess corp capital
      • ROE = [after-tax LOB income - charge for Tier 2 RC] / Tier 1 RC
      • calc charge for Tier2 RC as % of Tier 2 RC
        • This percentage is set so co achieves targeted ROE if all LBO achieve target ROE
      • company's LOBS will have different proportions of high/low risk capital needs
      • measures return on each LOBs high-risk capital while taking into account extra cost of add'l capital
      • more common in banking industry, but applicable to ins world as well
    • Allocation of Excess or Shortage of Capital
      • authors recommend
        • if viewed as temporary, allocate to corp segment
        • if viewed as perm, calc of req'd calc s/b revised to reflect this
      • alternate approach
        • allocate all capital in proportion to req'd capital for each LOB
      • results can be distorted by reins
        • if reins trx designed to help overall company, not just single line, may be appropriate to share costs and benefits across all lines
    • Rationing of Capital
      • particularly important when shortage of capital
      • difficult choices when capital is short
        • who should get it?
        • some LOB may bet it even w/ inferior returns if of strategic importance

• Basic Requirements
  • simple story that explains why company will succeed
  • told to employees, rating agencies, investors, customers (sometimes)
  • explains how co will apply competitive adv to serve mkts that provide opportunities for desirable profits and growth
  • embodied in co's vision, mission, strategy
  • to achieve goals, many areas need to work together
    • products developed
    • assets managed
    • reins/acq/divestitures coordinated w/ mgmt of risk, earnings, capital
    • find right balance between growth, profitability & risk to match availability of capital
• Financial Management Techniques
  • simple techinqes/behaviors that can help a co serve owners better
    • better to underpromise and overdeliver
    • make modestly conservative acctg adn reserving choices -> reduces chance of negative surprises
    • increase vigilance when times are good - tend to get overconfident and careless when times are good
    • timing is important w/ capital mkts
      • raise capital in advance of when you need it...when it is cheap
  • have bias toward opportunities w/ more upside than downside potential
  • options historically a major source of added earnings & unexpected losses
    • strive to include options that benefit co and minimize options that could hurt
  • build speed into org
    • many opportunities more attractive to those who react first
• Achieving Fin Goals for Mutual Policyowners
  • they want fin security adn max value from their pols
  • they don't care how fast/slow a co grows, just max value
  • when acq costs high and returns low, PPO may be better served by closing down NB & running off inforce and returning all capital to PO
• Demutualization
  • since mutuals return much value through PO divs, ROI/ROE often far below that for stock co
  • when demutualized, starts as stock co w/ very low ROE
  • effective way to unlock mutual PO's value in co w/o dismantling coin process
  • most use demutualization and opportunity of IPO to raise add'l capital
• Achieving Stockholder Financial Goals
  • want to maximize return through stock price appreciation & stockholder divs
  • stock price driven by 2 main factors
    • outlook for co and industry
    • recent history of co under current management team
  • largely a function of P/E ratios (stock price to EPS)
    • P/E ratios largely function of expected growth rate for co, tempered by current attractiveness of life ins industry
  • ins cos tend to have lower P/E ratios than stock mkt avg
  • if privately held, still a fair amt of importance to stockholder divs
    • public - not as important. Price appreciation now main focus
  • investors focus on stockholder reporting, not regulatory reporting
    • co can show negative solvency earnigns and investors will hardly notice
    • (rating agencies adn regulators WILL notice)
  • fast growing co typically has soaring stockholder earnings and plummeting solvency earnings
    • b/c of extreme conservatism in most solv reserves
  • slow growing co may experience opposite - solvency > stockholder reserves
    • as conservative solvency reserves released on old business
• Embedded Value (EV)
  • gaining acceptance in capital mkts as important fin measure
  • EV - PV of co's distributable earnings, including any current exess capital
    • future NB not included
    • EV represents run-off value for co, discounted @ given rate
  • why EV may become key driver of Life Ins Stock prices
    • used extensively in Europe
    • actuarial valuation tool
      • used by buyers to substantiate take-over prices
      • value of target in 3 pieces: EV, goodwill, multiple fo potential annual cost savings
    • allows investors to see how much of a co's current value is represetned by inforce business and how much is based on expected future growth
    • good test of recoverability of life ins intangibles (DAC)
      • EV of co s/b > DAC
    • should provide a minimum value for a LIC
  • Does have limitations
    • time and staff consuming to implement and maintain
    • sensitive adn can change significantly w/ assumption change
    • difficult to explain to mgmt and outside analysts from one perios to the next

• Planning
  • - Set Marketing objectives
  • - establish guidelines for implementation and control of mktg activities
• Organizing
  • - establish a framework for carrying out mktg plans
• Implementation
  • - Execute mktg plans
• Control
  • - analyze results
  • - evaluate performance
  • - make necessary changes

• +Corporate Planning
  • primarily strategic
  • consists of establishing company's overall business plan
  • top-down. begins by deining the company's mission - defines scope of org's business activities and business direction
  • Establishs Corp objectives - long term results co hopes to achieve
  • Outlines Coprorate Strategies - long term methods used to achieve objectives
  • must regularly evaluate plans to make sure still appropriate
• +Marketing Planning
  • bottom up portion of planning process

• 1-5 years into the future. review and update as necessary. as oftern as every 6 months. focus on long term
• - establishes marketplace objectives
• - defines the target market
• - develops mktplace stategies
• - defines resource needs

• 1-2 years into the future - focus on the day-to-day
• - develops action-oreineted product, price, distribution and promotion tactics
• - describes when activities will take place, how they will be performed and who will perform them

• 3 primary activities: analyze situation, establish objectives, develop course of action
• Conducting a Situation Analysis
  • 3 primary parts: environmental analysis, environmental forcast, internal assessment
  • Environmental Analysis - ongoing exam of outside events/relationships that can influence strategic decion making
    • Key environmental areas for Financial Services Corp (fig 5-3 p 105)
      • - current target markets
      • - competition
      • - economy
      • - society
      • - technology
      • - regulation
      • - labor
      • - distributors
      • - international conditions
  • Environmental Forcast - prediction of major environmental trends that will affect a companies business activities
    • several types of forcasts available from businesses, universities, governments and industry associations
    • commercial forcasts are a good starting point
  • Internal Assessment - exam of co's current activities, strenghts, weekenesses and ability to respond to potential threats & opportunities in environment
    • internal factors that have greatest effect on co's mktg planning:
      • - mission
      • - fin, tech, human resources
      • - current distribution systems
      • - product lines
      • - operational efficiency
• Tools of Analysis
  • SWOT Analysis
    • Strengths, Weaknesses, Opportunities and Threats
    • Mktg Opportunity arises when right combo of circumstances allows co to use its strenghts to take advantage
    • Strategic Window - time period where optimum fit between co's distinct capabilities and key requirements of mktg opportunity
  • Business Portfolio Analysis
    • allows co to evaluate business units according ot their potential contribution to co
    • determines units potential for:
      • - generating financial resources
      • - requiring financial resources
    • SBU - strategic business unit
      • - operated as a separate profit center
      • - own seperate set/share of customers adn competitors
      • - own mgmt (generally)
      • - owm mktg strategy
    • Marketshare/Mkt Growth matrix - Boston Consulting Group
      • - Star - high mkt share, high growth mkt - becomes a cash cow when mkt growth slows
      • - Cash Cow - high mkt share, low growth mkt
        • primary role - provide income to cover corp overhead, pay divs, finance R&D
      • - Question Mark (aka Problem Child) - low mkt share, hight growth mkt
        • requires more cash than they generate
      • - Dog - low mkt share, low growth mkt
        • generate enough revenue to cover their own expenses
        • unlikely to become stars or cash cows
      • many SBUs have the following life cycle
        • Question Mark -> Star -> Cash Cow -> Dog -> sold/discontinued
    • Market Attractiveness/Business Strength Matrix - GE and McKinsey & Co
      • created to address problems w/ mktshare/mkt growth matrix
      • 9 matrix cells
      • business strength - strong/average/weak (x-axis)
      • mkt attractiveness - high/medium/low (y-axis)
      • "A" - good investment/growth opportunity
      • "B" - average opportunities
      • "C" - little growth/investment potential
        • high A A B
          • med A B C
          • low B C C
            • strg avg weak
      • mkt attractivness - composite index - uncontrollable env factors
        • - market size - market growth rate
        • - gov't regulation - mkt stability
        • - competitive intensity - tech reqmnts
      • business strength - composite index - controllable factors
        • - price competitivness - product quality
        • - customer loyalty - mktg skills
        • - sales growth rate - relative cost advantages
        • - tech and fin resources

• objectives s/b
  • - clearly stated
  • - specific and measurable
  • - realistic
  • - actionable
• objective shoudl specify (in quantifiable terms) what is to be accomplished and time period to accomplish it
• Corp Objectives - normally 1-5 years
• Marketing Objectives
  • primary - describe overall mkt response they hope to achieve in target mkt
  • secondary - cover mktg functionnnnnnns needed to carry out plan

• Corporate Strategies
  • - intensive growth strategy - usually requires significant financial resource
    • + Market Penetration - increasing sales of current products to current mkts
    • + Mkt Development - increasing sales of current products to new mkts
    • + Product Development - increasing sales of new/modified products to current mkts
  • - diversified growth strategy - venture beyond normal business domains
    • + Horizontal Diversification - intro diff products to co's current mkt
    • + Concentric Diversification - new mkts, new products similar to current products or current mktg methods
    • + Conglomerate Diversification - new mkts, new products that bear no relationship to curernt products
      • same product related new product unrelated new product
    • new mkt mkt development concentric diversification conglomerate diversification
    • same mkt mkt penetration product development horizontal diversification
  • - Integrated Growth Strategy - taking over another level of industry or dist channel
    • + Forward Integration - control of distribution channel
    • + Backward Integration - upstream (manufacturer or supplier)
    • + Horizontal - competitor
• Marketing Strategies
  • focus w/r to SBU's mkt share
  • + Build Strategy - increase mkt share. usually S/T loss (capital outlay) for L/T gain
    • most appropriate w/ relatively low mktshare in relatively high growth rate mkts
    • Question Marks or "A"s
  • + Hold Strategy - maintain mkt share
    • Cash Cows or "B"s
    • appropriate for high mkt shares in low growth mkts
  • + Harvest Strategy - maximize S/T earnings and cash flow
    • appropriate for weak growth potential
    • weak Cash Cows, Qeustion Marks, Dogs adn "C"s
  • + Withdrawal Strategy - selling/discontinuing a SBU
    • appropriate for weakest growth and inv potential
• Tactical/Action Programs
  • - what activites are to be performed
  • - how/when/where they are to be performed
  • - who is responsible for performing each activity
  • - how much each activity will cost
  • - type and magnitude of results expected from each activity
  • - main elements of uncertainty involved
  • - how results will be monitored and evaluated
  • Benchmarking - identify best practices adn outcomes
    • - emulate best practices to equal/surpass best outcomes
    • avoids reinventing the wheel
  • programs must be coordinated and integrated to be successful
  • formed for each marketing area and combined to form annual mktg plan
• Setting Budgets
  • tell Sr Mgmt how much and when - bottom up
  • sometimes top down and funds need to be allocated. Proposed programs scaled up/down as necessary
  • budgets provide feasibility info

• written document that specifies marketing goals for a product/product line and describes strategies and implementation and control efforts co intend to use to achieve those goals
• focuses on target markets and elements of marketing mix
• Benefits
  • - facilitates communications among all levels of org and among function units
  • - allows mgmt to monitor consistency of actions across units
  • - focuses EE on right issues
  • - keeps poeple focused on overall goals
  • - provides basis of performance comparison
• Elements
  • - executive summary
  • - situation analysis
  • - mktg objectives
  • - mktg strategies
  • - tactical/action programs
  • - budgets
  • - control mechanisms

• Essential Mktg Functions
  • - Information Management
  • - Marketing research
  • - product development and pricing
  • - sales and distribution
  • - advertising, sales promotion and publicity (aka Mktg Communications)
  • - customer relations
  • - mktg personnel development
  • - mktg mgmt and admin
• Four common mktg structures: function/product/geog region/customer type
• Organization by Function
  • most common
  • different areas of responsibility depending on work performed
  • ex. Chief Mktg Officer/Mkt Research Mgr/Sales Mgr/etc
  • Advantages
    • - simplicity
    • - focuses on developemnt of managerial and tech skills
  • works best w/ small cos or cos w/ homogenous customers
• Organization by Product
  • each SBU responsible for its mktg (most of)
  • may be some shared services
• Organization by Geographic Region
  • usually mktg manager for each region
  • usually some shared services
• Organization by Customer Type
  • mktg manager for each division
  • ex: households/small business/big business
• Combination Structures
  • flexible - meets both co's strategic implementation needs and customer needs
  • Matrix Organizational Structure
    • project manager directs individuals from different function areas
    • two bosses during project

• Mktg Implementation - process of translating mktg plans and strategies into action
• accomplished through day-to-day tactical and operational activities

• marketing control - process of examing results of mktg plans and company to plan and taking actoin to keep it on track

• performance std - internal vs external std
  • - usually incorporated into mktg plan
• management by exception - mgmt only gets involved if performance outside acceptable range
  • - saves time and allows attention to be focused on problems/opportunities
• if a problem, read to identify toe cause and take actions to correct
  • - change tactical/action programs
  • - establish new implementation method
  • - new strategies
  • - modify how performance data collected/analyzed
  • - re-evaluate performance standards
• control tools
  • sales analysis vs
    • - forcasted sales - prior years sales
    • - expenses to generate sales - competitors' sales
    • - estimated mkt potential - current industry sales
  • measured - # products, 1st yr comm, face ,avg prem, etc
  • expense analysis
    • natuaral accounts - ledger accounts
    • functional accounts - based on purpose
    • expense ratios - ex. mktg expenses/$1m face sold
  • profitability analysis
    • compares sales to expense incurred to generate sales
    • use several years data since for line ins, 1st yr expenses > 1st yr revenues
    • valuable source of info since combines sales and expense info
  • mktg audit
    • systematic examination and appraisal of mktg environment, objectives, startegies, tactical/action prgms, organiztional structure and personnel
    • key areas of mktg audit (chart p 135)
      • mktg environment
        • macro environment
        • task environment
          • mkts adn customers
          • other factors in mktg system
      • mktg strategy
        • business mission and mktg objectives
        • mktg strategy
        • budgets
      • mktg organization
        • formal structure
        • functional efficiency
        • cross-functional efficiency
      • mktg systems audit
        • mktg info system
        • mktg planning system
        • mktg control system
        • new product developemnt
      • mktg productivity audit
        • profitability analysis
        • cost-effeciveness analysis
      • mktg function audit
        • products
        • price
        • distribution
        • promotion
  • Reporting Sytems
    • - provide managers w/ detailed summary info as needed
    • - provide accurate adn timely info
    • - be flexible to adjust to co's changing info needs
    • - be cost effective
    • - easily understood by
      • + those who evaluate performance
      • + those whose performance is being measured
    • detail s/b appropriate for level
      • lower level needs more detail
      • higher level mgmt needs just summary

• dividing large markets into smaller markets w/ similar product/mktg mix needs
• single variable segmentation - only 1 variable to segment market
• multiVariable segmentation - uses combo of variables
• Requirements for Effective Segmentation
  • - customers should have similar product needs/buying habits
  • - needs/behaviours s/b distinguishable from other segments
  • - potential sales/costs/profits s/b lare enough to be measured and compared to other segments
  • - profit potential enough to warrant segment attention
  • - customers accessible thorugh currently available means
  • - size/composition s/b relatively stable over planning period
• Bases for Segmenting Consumer Markets
  • Geographic Segmentation
    • country/region/state/county/zip/legal boundaries/rural-suburuban/urban
  • Demographic Segmentation
    • age/sex.marital.household composition/income/education/occupation/family life cycle/nationality/race/etchic group/social class
  • GeoDemographic Segmentation - combo of geographic adn demographic
    • economic means/cultural background/perspective/neighborhood
  • Psychographic Segmentation
    • lifestyle/activities/interests/opinions
  • Behavioristic Segmentation
    • benefits sought/usage rate/buyer readiness/pref method of purchase/risk tolerance/buyer loyalty
  • Demographic - commoonly used in consumer markets
    • traditional life ins demographics - hi/middle/low-income households and families/boomers/seniors
• Bases for Segmenting Organizational Markets
  • Organizational Mkts - group benefits and continuation of business operations
    • therefore two markets, group and business
  • Georgraphic Segmentation - simialr to consumar markets
  • Demographic Charachteristics
    • business activity/type of group-organizatoin/size of group-organization
    • SIC - Std Industrial Classification - 1930
    • NAICS - N. American Industry Classificatino System - by-product of NAFTA
    • small groups <=100 - 80% of contracts, 25% or prem
    • medium groups 101-499 - 10% of contracts, 25% of premiums
    • large groups 500+ - 10% of contract, 50% of prem
  • Behavioristic Segmentation
    • similar to consumer markets - usage is a key

• process to identify, select and focus mktg efforts
• Evaluating Potential Target Markets
  • Mkt Size and Growth Potential
    • majority fallacy - blind pursuit of largest, most easily identified or most accessible mkt segment
    • competition makes big mkts less profitable
    • should offer combo size/growth/profitability that best meets co's needs
  • Mkt Attractiveness
    • depends on level of compettition and buying power of consumers
  • Company Goals and Resources
    • only puruse targets if it has (can easily get) fin/tech/hr necessary to compete sucessfully
• Target Mktg Strategies
  • Undifferentiate Mktg - mass mktg - singel mktg mix for entire mkt
    • + cheaper since only one mkt strategy
    • - might miss differences w/in segment
    • - disadvantage to specialty marketers
  • Concentrated Mktg
    • for a product - focus all mktg efforts on a single segment of total mkt
    • Niche Mktg - form of concentrated mktg w/ narrowly defined mkt
    • - all eggs in one basket
    • + can be profitable
  • Differntiated Mktg
    • offer differing product/mktg mixes to appeal to diff segments
    • - most expensive
    • + better served customers = incr customer satisfaction = incr sales
  • Factors to consider when picking mktg strategy
    • company resources - if limited, concentrated probably best strategy
    • product variability - homogenous products - undifferentiated mktg
    • Mkt Variability - if buyers have similar usage/purchase patterns - undifferentiated
    • product's life cycle stage - new products - concentrated/undiffernetiated
      • - mature -differentiated
• Consumer and Organizational Target Markets for Ins Products
  • Affluent Consumers
    • mass affluent - 100k -$1mil liquid assets - 99.9% of affluent mkt, 54% of total mkt assets
    • high-net-worth - $1-25 mil liquid assets - 0.1% of mkt, 31.3% of assets
    • ultra-high-net-worth - 0.001%, 15.1% of total mkt assets
  • Single-Parent Families - need large amt ins to protect single wage earner
  • Non-family Households - low need for life ins, high need for health/retirement products
  • Working Women - strong potential for wide range of products
  • Employer Groups - ex. negotiate trusteeship/voluntary trade assoc/MEWA
  • Small Businesses - rapidly growing segment - approx 99% of businesses are small businesses
    • significant market for products that
      • - protect against loss due to death/dis of owner
      • - preserve value/prevent liquidation due to owner/partner death
      • - preserve sharelohlder equity/mgmt control due to majority shareholder death
      • - protect against death tax on inherited business
      • - enhance credit/fin stability by assuring business continuation
      • - source of emergency funds
      • - non-qual def comp to attract/retain key employees
      • - EE health/life/dis ins and qual ret plans

• Major Innovations - new prduct that meets needs not addressed before by other products
• Start-up Businesses - new product for a mkt served by a similar product
• New Prroducts for Currently Served mkts - new product for co, but product avail from other cos
• Prodcut Line Extensions - new product forms adn items to existing product line to give customers wider choice
• Product Modifications - characteristic changed ot allow competitive advantage over similar prod
• Style Changes - alter appearances or tangible aspects (ie logo change)

• 5 basic steps - after first 3 steps (each one) decide continue/abandon/refine
• Product Planning/Business Analysis/Tech Design/Implementation/Monitor & Review
• Product Planning
  • Idea generation
  • Screening
    • two potential screening errors
      • - potential of a good idea underestimated and idea rejected
      • - poor idea looks deceptively attractive and pursuded, wasting resources
    • may use a screening critera checklist to help objectively screen
      • - compatible w/ corp goals and strategic inititiatives
      • - will prodcut enhance copr image
      • - does a need exist in target market
      • - can current prodcut be modified to meet this need
      • - will product generate new sales or shift sales
      • - mkt potential large enough to generate enough business to make product profitable
      • - can product be mkted through existing methods
      • - support a level of commissions that will motivate slaes force
      • - can current systems handle the product
      • - will target mkts understand the product
      • - would it be more attractive if offerred thorugh a sub
    • Concept Testing - measures acceptability w/o actually producing items
      • - helps determine how customers would compare product ot existing products
      • - what sets of benefits/attributes customers like most
      • - which ideas are unacceptable in the mktplace
      • - which target mkt to taimfor
    • Field Advisory Council - group of agents to test new ideas on for feedback
• Comprehensive Business Analysis
  • Mkt Analysis - study of environmental factors that might affect sales
    • - potential value of product ot customers
    • - nature adn size of target mkt
    • - potential value of product to company
    • - nature of products competition inthe mkt
    • - customer appeal of product
    • - appeal of product to distributors
    • - products relationship to other products offered by co
    • - potential legal/regulatory problems w/ product
    • - special tax considerations
    • - economic considerations
    • - product/company fit
  • Product Design Objectives - products basic characteristics/features/benefits/issue lmits/u/w classes/etc
  • Feasibility Study - operational & technical viability of producing/offering/admin of product
  • Mktg Plan - outlined in C 5
  • Prelim Sales & Fin Forcasts
  • If analysis indicates good potential, product proposal prepared for mgmt
  • Product proposal typically details
    • - product objectives - product description
    • - mktg strategy - mktg fit
    • - fin fit - inv fit
    • - systems fit - scope of product implementation
    • - legal/regulatory
• Techical Design
  • writing contract/actuarial assumptions/rate structure/benefit levels/issue u/w standards
  • usually several revisions utnil compromise reached
  • prod dev process flow/timeline/budget assembled
  • all put together and presented to management
  • areas involved
    • Mkts/Distributors/IS/Actuarial/Investments/Admin/Acctg/Legal-Compliance
• Implementation
  • establishing admin structure adn processes necessary to take product to market
  • 3 concurrent activities
    • - obtain necessary legal approvals
    • - design promo & training materials
    • - develop IS systems/procedure to mkt & admin product
  • Policy filing - dynamic process b/c state variations
  • Design of Promotion and Training Materials - product naem, sales lit
    • need to get approval from legal on most materials
    • some might need state approvals
  • Systems Activities
    • IS might need to buy/develop new systems to support product
    • usually takes greatest amount of time in process
  • Product Introduction
    • offering new product for sale and having mktg and product support in place
    • Intro sales kit
      • - outline of product features and how they work
      • - desc adn sample of policy and fin statement insured will get each year
      • - table of issue and u/w limits
      • - commission scales
      • - table of premium rates
      • - list of possible mkts
      • - sample illustrations
      • - saels presentations
      • - suggested sales solutions for diff mkt situations
      • - samples of local and national advertising to intor product to public
      • - sample pre-approach letter adn/or postcards
      • - booklet about product for producer
      • - brocure about product to give to prospects
      • - prospectus (if req'd)
      • - sample app
      • - details on promo campaign
      • - privace disclosures
      • - instructions on how to access website for more info
    • Training classes
    • Incentive prizes/awards
• Sales Monitoring and Review
  • review PD cycle to see if time/budget met
  • review sales to see if matching forecast - if not, attempt to determin why
  • check fin results to see if goals met
  • Product Modification
    • - s/b systematic as development for new products
    • - changes might occurr because of actual sales/profit experience
  • Product Withdrawal
    • sometimes necessary b/c of legal regs
    • sometimes end of lifecycle or unprofitable
    • may meet resistance from agents
    • good to have an acceptable replacement product
    • review portfolio periodically to see if anything should go

• Pricing Objectives - goal co wants to achieve when pricing profit
  • ideally stated in writing so they can be verified against actual results
  • Profit-Oriented Pricing objectives
    • Profits (or contributions to surplus)
    • Target return objective - specific level of profit as an objective
      • often used to evaluate performance
  • Sales-Oriented Pricing Objective
    • Mkt share
    • Types of competition-oriented pricing objectives
      • - discouraging the competition
      • - beating the competition
      • - meeting the competition
    • nonprice competition - product features, quality customer service, etc
• Cost - a big unknown since costs not known until blocksize = 0
  • projected costs a big estimate
  • some costs hare to split by product
  • Direct Cost - directly attibutable to the product (u/w cost/comm/etc)
  • Indirect Cost - not directly attributable (rent/shared services/etc)
  • Fixed Cost - constant regardless of volume sold (rent/utils/prod dev/etc)
  • Variable Cost - varys w/ volume (pol issue/prem tax/comm/etc)
• Demand - determines upper limit of products' price
  • Price Elasticity - % change in qty demanded / % change in price
  • Elastic Demand - change in price results in greater than proportional change in qty demanded
  • Inelastic Demand - change in price results in less than proportional change in qty demanded
  • Price elasticity depends on
    • - number of substitute products available
    • - need associated w/ product
    • - level of expenditure req'd to purchase a product
• Customer Influences
  • Purchasing Power (aka buying power) - measure ability of customer to buy goods and services
    • affected by economic conditions - inflation/taxes/unemployment
  • Price Consciousness - importance that customers attach to price
  • Price Flexibility Desired - guaranteed price stability vs risk of higher price for chance at savings
• Competition
  • - number of competitors and competing products
  • - cost factors assoc w/ product and level of costs facing each competitor
  • - level of fin resources avail to each competitor
  • - level or resources each competitor has already commited to product
  • - historic pricing behavior of each competitor
  • - expected reaction of each competitor to price changes
  • - each competitors overall strengths and weaknesses
• Regulatory Requirements
  • need apporval for healt ins rates. Normally not for life ins
  • solvency requirements
  • XXX
• Other Mktg Mix Variables
  • Type of promo efforst, form of distribution and product (features, benefits, levels of service, etc) aslo affect overall price

• Cost-Driven Pricing Strategies
  • establish price that will cover all costs and profit objectives
  • most effective if a market leader
  • might also work if
    • - exclusive agent force
    • - little competition
    • - exclusive access to customer base (worksite)
    • - fraternal
  • can be problematic in competitive mkt situations
• Competition-Driven Pricing Strategies
  • base price on competitors price and place in market hierarchy
  • adjust conversion/renewability options, commissions to arrive at price (ie. products modified to fit price)
  • Penetration Pricing - low price to build mkt share
  • Flexible Pricing - negotiable price w/ each customer
    • competitive bidding
    • negotiated contract
• Customer-Driven Pricing Strategies
  • usually focuses on compensation element of pricing
  • focus on "product value"
  • Psychological pricing - certain types of prices more appealing to customers
    • 99.95 vs 100 or monthly vs annual
  • Price Skimming - charging highest possible price that customers who most desire product will pay
    • more true for tech than for fin services
  • Promotional Pricing - lower (than normal) prices on certain items to stimulate all sales
  • Price Leaders - low cost products to attract customers to all products at regular prices
  • Loss Leaders - price leaders priced below cost

• Preferred Risk Discounts - better rates for those with characteristics of loewr mortality
• Quantity Discounts - rates graded by size of policy
  • banding
  • policy fee system
• Gender Based Pricing - like PRD - know difference in M/F mortality
• Market-by-market pricing - different rates by jurisdiction/geor area/target market/prem taxes/mandated product features/reserve requirements
• Contingency Pricing - adjustable premiums/experience refunds
• High & Early cash value pricing - used on UL for early buildup of Cd
  • intial prem rates higher to pay for this
• High and Late CV pricing - lower early prems
  • discourages early surrenders w/ SC
• Indeterminate premium pricing - dual prem structure - curr and guar

• specific procedure co uses to set final price (or price structure) for a product
• cost-based/competition-based/customer-based
• Asset Share Calculation
  • Asset Share - amount of assets a block will have accum at any given time
  • Asset Share Calc - mathematical simulation of A/L/Surp interaction over years on a block
  • Basic steps
    • - establish gross prem based on estimate costs/demand and competition - starting point
    • - choose conservative mort talbe and int rate to calc products reserves
    • - choose more liberal mort and higher in to estimate NP req'd to pay benefits
    • - choose a div assumptoin, expense rate, lapse rate nad profit margin objective for all years
  • Validation period - breakeven period - time req'd for product to become profitable or begin adding to surplus
  • Validation point - end of validation period
  • if validation period is too long, co will abandon product or adjust assumptions
    • increase GP or lower benefits/expenses

• assess
  • - price's impact on co's fin performance
  • - impact on performance of producers & other distributors
  • - reactions of both competitors and customers
• factors to monitor
  • - investment margin
  • - u/w margin
  • - expense margin
  • - lapses (diff between actual and expected)
  • - taxes (actual vs expected)

• Pricing a Product Line
  • rank each item from lowest to highest price and determine price of each item
  • need price set to cover all product line costs
  • if one item is priced low to meet competition, other need higher prices to make up diff
• Pricing a Product Portfolio
  • need ot ensure all products cover all costs
  • model office - whole co model - can help verify pricing is correct for entire portfolio

• ROE = GAAP Income / Prior YE GAAP equity
  • corp profitability measure common in ins industry
• relationship between pricing objective ROI and corp profit measure ROE
• examing relationship between ROE and after-tax ROE
• StatSurplus(t) = StatSurlus(t-1) + StatIncome(t) - Dividend(t)
• GAAPEquity(t) = GAAPEquity(t-1) + GAAPIncome - Dividend(t)
• StatIncome(t) = BookProfit(t) + i*(StatSurplus(t-1))
• DAC(t) = DAC(t-1) - (DAC(0)*g*v^(w-t+1))/(1-v^w)
  • v = 1/(1+g) where g = i from DAC amort sched and w is amort period
• GAAPIncome(t) = StatIncome(t) - DAC(t-1) + DAC(t)
• ROE = GAAP Income / GAAP Equity
• example shows what happens if DAC < ROI adn i < ROI
• since i < ROI, stat income invested @ lower rate, brings down ROE below ROI
• DAC amortizes more at lower rate than ROI rate which brings down ROE in early years
  • trend reverses in later years
• can fix i < ROI problem by releasing Stat Income via divs to other LOB or to stockholders
• ignoring taxes, 2 main reasons why ROI = ROE objective is prevented
  • stat surplus not used to acq NB will hurt performance if surplus not earning an annual return equal to RO objective
  • GAAP requires degree of conservatism.
    • Eliminates use of annual ROI pricing objective as inv earnings rate in development of DAC amort sched and benefit reserve
      • therefore earnings deferred to later years and result is non-leve (incr) emergence of ROE

• ROI is minimally affected by FIT
• intro of FIT dramatically changes relationship of ROI to ROE
• 1st yr ROE reduced by factor of (1-T) - since initial equity not affected by after-tax ROE
• for ROE=ROI, GAAPEquity(t) = (1-T)DAC(t) w/ DAC amortized @ ROI
  • and stat surplus = 0 or reinvested @ ROI/(1-t)
• a company holding surplus, invested at rate < ROI/(1-T), en excess of that necessary to producce new business &/or producing new business cannot produce a compnay-wide after-tax ROE = ROI pricing objective
  • unless it owns a block w/ an after-tax ROE > company-wide after-tax ROE objective
  • This could occur
    • past business priced to produce ROI > current objective and pricng assumptions met
    • experience emerged more favorably than was anticipated in pricing
    • past accts practices were conservative and deferred earnings
• Potential soln - price new products using ROI objective > corp after-tax ROE objective
  • advantages
    • if corp after-tax ROE < ROI, will meet ROE goal quicker
    • in later years, renewal business ROE would = ROI which is > corp ROE goal which will offset negative effect that production of NB has on corp ROE
  • if goal was to meet ROE goal in 1st year, ROI pricing objective = ROE/(1-T)
    • and renew ROE > corp ROE (approaches ROI) if suplus dividended out
    • GAAP won't allow ROI as amort schedule rate
  • marketplace may not allow success of ins product w/ ROI that high
• non-ins industries produce returns by leveraging equity w/ debt
• stat acctg principle eliminate this option for LIC
  • equity (not just current assets) needed to acq new life ins business
• need to leverage new business w/ old
• growth in ne production dictated by
  • past and current acct practices
  • reinvestment adn stockholder div practices
  • age of existing blocks
  • relative size of existing blocks vs NB
• reinvestment and stock div practices must consider degree of risk assoc w/ existing block
• stat surplus in excess of what is needed to produce NB must be maintained and amt ret depends on risk elements assoc w/ block
  • therefore, get effect on after-tax ROE of maintainnig this surplus must be considered when detererming how much NB can be writeene w/in ROE constraints
• Soln: calc ROI on new products on basis of stat "reserve" = reserve + add'l amt needed as risk surplus to ensure solvency of LOB (benchmark surplus)
• ROE = ROI shoudl emerge even though sufficient assets avail to ensure solvency

• conclusions drawn from examples not dependent upon specific emergence of SAP profits assumed
  • by def, Sum(PVProfit_SAP) = 0 @ ROI rate
  • therefore sum(PVProfit_GAAP) = 0 @ ROI rate
• if inv earning rate for GAAP = ROI and all other assumptions = pricing
  • GAAP book profit each year (leveled as % prem) must = 0
• ROE = ROI regardless of emergence of SAP profits if SAP-GAAP adjustments assume inv earning rate = ROI

• DEFRA mess w/ GAAP income and ROE b/c of "fresh start"
  • need to be taken into consideration during corp planning process

• Relationship between ROI and ROE dependent on # items
  • past and current Acctg practices
  • past and future reinsvestment and stockholder div practices
  • risk assoc w/ existing block and stat suplus req'd to insure co's future solvency
  • age of existing block of business
  • relative size of existing block when compared to NB to be produced.

• Introduction
  • examples of models taht use expereince assumptions
    • pricing adn repricing studies
    • product design studies
    • determination of reserve adequacy
    • financial reporting (DAC)
    • financial projections or forecasts
    • actuarial appraisals
• categories of experience assumptions
  • cash flow view
    • 3 broad categories
      • obligation or liability assumptions - mort, lapse, admin exp, taxes, div and int crediting strategies
      • asset assumptions - earnings rates, default, inv expenses, inv strategy
      • scenario assumptions - scenario(s) being analyzed
  • degree of conservatism
    • best estimate or include PAD - depends on how used
      • acctg rules may require w/ or w/o PADs
      • acctg/regulatory rules may prescribe assumption (may or may not be conservative)
    • best estimate assumptions represents actuary's judgement as to most likely outcome
      • if in doubt - pick more conservative choice
      • in fin reporting context - conservative assumption means w/ higher liability or smaller asset
      • in pricing context - lower benfit or higher charge to customer
    • PAD should consider degree assumption is at risk in total and by duration
    • adjusting a PAD shoudl make result more conservative
    • prescribed assumptions usually contain implied PAD
      • if doesn't seem conservative, test w/ realistic assumptions
• Establishing Experience Assumptions
  • steps necessary to develop assumptions
    • identify assumptions req'd
    • determine structure of each assumption
    • analyze experience and trends in experience for each assumption
    • review and adjut set of all assumptions for reasonableness, consistency, and appropriateness
    • document assumptoins
    • monitor experience and update assumptions
  • Identify Assumptions Req'd
    • depends on model - different simplifying assumptions based on model purpose
    • common assumptions
      • obligation (liab) assumptions
        • mort/morb rates tax rates
        • lapse rates incidence and level of prem payments
        • expense rates reins results
      • Asset Assumptions
        • inv earnings rate default rates
        • capital gains rates inv expenses
      • Scenario Assumptions
        • specified set of deterministic int rate scenarios
        • stochastically generated int rate scenario
        • set of possible economic scenarios
        • set of sensitivity tests
  • Determining Structure of Each Assumption
    • can be very simple or very complex depending on model and purpose and materiality
    • assumptions determined for particular experience class
    • purpose of grouping - establish homogenous groups for analysis expected to generate similar experience
    • experience class consists of all contracts that
      • similar type (UL/Term/WL/etc)
      • same structure of charges/benefits
      • issued over continuous time period
      • similar mktg objects
    • different assumptoins might have different classifications
    • experience class used for pricing shoudl remain in tact - OK to merge w/ another class, but not split
    • key principles to decide on complexity of assumption structure
      • differences in exp assumptions shoudl reflect differences in experience
        • ok to vary mort by IA/sex/smoker/dur
        • ok to vary lapse by mode of payment
      • if no differences in an assumption, don't split
      • definition of class s/b objective and easily understood
      • # class s/b practical and cost effective
        • balance between precision and expense
  • Analyze Experience adn Trends in Expereince for Each Assumption
    • evaluate credibility of data
      • homogenity of data - ex. split out substd from std for mort
      • reasonability of methods and results
    • Evaluate quality of data
      • understand the data and how it will be used
        • possible alternate sources of data - balanced w/ practicality
          • can it be obtained in a reasonable time at a reasonable cost
        • appropriateness of data - recent? limitations? biases?
        • reasonableness and comprehensiveness of data - internally and externally consistent
    • Use Actual or similar experience
      • s/b that of class of business assumption applies to, provided experience is determinalbe, available, and credible
        • aka actual experience
      • if actual experience not determinable, available, or credible, base assumptions on
        • "similar expereince" from same company
        • similar business other cos
        • other sources
        • in this order
    • Reflect Trends in Exp as Appropriate
      • evaluate trends and make judgemenet whether trends will continue
      • ok to ingore trends if doing so is conservative or not permitted in regs
    • Reflect Company and external Factors
      • review company business practices and reflect in assumptions
      • esp true if company practices changed recently or will shortly or if relying on other co data w/ diff business practices
      • mort rates shoudl reflect selection criteria for each rating class
        • freq of u/w exceptions, reinstatement reqs, etc
      • inv assumptions shoudl be consistent w/ limits on asset type, quality, duration, convexity
        • different assumptions for each segment if appropriate
    • Sensitivity Test Assumptions
      • test to show impact of probable deviations that could have material financial effects
      • standard stat tests or historical exp for likely range
  • Review & Adjust Set of all assumptions for Reasonableness, Comsistency, & Appropriateness
    • generally not a single assumption but a range fo assumptions that are consistent w/ underlying data
    • set of assumptoins s/b comprehensive and internally consistent
    • consistency checks
      • inflation assumptions for expenses consistent w/ inv earning assumptions
      • mort anti-selection assumptions consistent w/ lapse assumptions
      • u/w exense and mort rates consistent w/ u/w practices
      • inv expenses and returns consistent w/ inv policy
    • model validation chekcs
      • does model produce aggregate reserves consistent w/ most recent valuation
      • does model produce cahnge in reserve in future years consistent w/ past trends in actual reserves
  • Document Assumptions
    • Documentation of experience assumptions should cover
      • what the assumption is
      • data underlying the assumption
      • how assumption was developed
      • how to use the assumption
  • Monitor Experience and Update Assumptions
    • need ot be reviewed and updated on a regular basis
    • just because you reviewed doesn't mean you have to change it

• normally of form of table of rates varying by IA and duration since issue
• q(x,t) = q(y,s) if x+t = y+s adn t>n and s > n (ultimates s/b in sync)
• q(x,t) <= q(y,s) if x+t = y+s and t<s and t<= n (same AA, qx for one closer to issue)
• ANB <=> ALB - normally just average rates @ adjacent ages
  • q_ALB(x) = 1/2*(q_ANB(x) + q_ANB(x+1))
  • q_ANB(x) = 1/2*(q_ALB(x-1) + q_ALB(x))
• M/F smoker/nonsmoker have signficantly different mort rates and relationship si NOT a simple multiple
• other distinctions usually just expressed as a multiple or other simple mod
• credibility of data plays role in whether experssed as multiple or completely different table
• common variations in mort class
  • risk selection class
  • selection process - simplified/guar iss blood/no blood
  • size of policy - usually lower mort for higher face
  • misc - mktg method, plan type, policy provisions, other
• Analyzing Experience
  • Credibility
    • confidence intervals - convenient way to judge credibility of co's experience
      • 95% conf interval (of expected claims) E+/-1.96(VAR^.5)
      • E = expected = nq
      • Var = npq (for claims)
      • 95% conf interval of mort rate [E+/-1.96(VAR^.5)]/n
  • Risks Covered
    • normally studies done on "std" issues and exclude
      • policies not subject to normal u/w stds (GIO/group conv/term conv/simpl/guar iss)
      • substd policies
      • policies inforce under ETI/RPU
      • multple life policies
      • sep studies for excluded policies
        • then use a multiple or other mod to std table
      • multiple life mort generally derived from single life mort assumptions
  • Mortality Studies
    • anniv to anniv studies and calendar year studies
    • ways into study - A-inforce @ BOP and N - new entract (age x+ r)
    • ways out - B - inforce EOP W - w/d (age x+s) D- death
    • use Balducci assumption for dist of deaths
    • q(x) = D / [A + (1-r)N - (1-s)W]
    • exposure for a cell - seriatim or aggregate
      • if aggregate, use mid-year assumption for entry/w/d
      • 6 ways to get through study and their exposure
      • (A,W) s
      • (A,B) 1
      • (A,D) 1 <- no deduction for deaths)
      • (N,W) s-r
      • (N,D) 1-r
      • (N,B) 1-r
      • sum up indiv exposure to get total exposure
      • aggregate - exposure = 1/2[P(x,z) + P(x,z+1) + D(x,z)]
        • using calendar year-end inforce data and deaths
  • Other Aspects of Mortality Studies
    • need to look at several years for credibility concerns
    • too long a study might not be representative of recent experience
    • usually 5 years of data
    • usually policy count or amt (or both ) study basis
    • count basis
      • distorted by multiple policies by same insured
      • if overall # pols in large, s/b not an issue
    • amount basis
      • shows financial impact
      • generally preferred
      • credibility not as high as count (b/c of variation in amts of ins)
  • Enhancing Credibility
    • grouping IA & durations together can enhance credibility
    • similar to adding years to study
    • grouped results smoothed
    • A/E analysis can also help credibility
  • Credibility of A/E Ratios
    • Var(expected # claims) = sum(pq)
    • 95% conf interval of claims (CIC)
      • E[# claims] +/-1.96*sqrt(var(# claims))
    • 95% Conf Interval of mort ratio = CIC / E[# claims]
    • Var(amt claims) = sum(A(i)^2*q(i)*p(i)) where A is Amt of ins
    • E[amt claims] = sum(A(i)q(i)
    • conf interval - amt of claims E[amt claims]+/-1.96*sqrt(var(amt claims))
    • variation in policy size can increase size of confidence interval
  • Adjusting Mortality Tables for Special Situations
    • some mort assumptions derived from mort tables, not developed by study
    • multiple life/substd
    • Term conversions
      • expected mortality is higher than regular u/w polices and needs to be accounted for in pricing and other models
      • include term conv in regular mortality study and have all permanent policies share extra mort cost
      • include charge in term pricing for PV of cost of extra anticipated mort on perm policy
        • (q_c([x]+t+s) - q_s([x+t]+s)*NAR(s) <- cost of extra mort in year s after conv
      • can do sep study on converted policy mortality if enough data
      • extra mort can be estimated by making assumption about degree of anti-selection
    • Anti-Selection
      • several situations when PO can be expected to antiselect
        • when ART rate @ renewal is higher than newly u/w policy
          • if healthy enough to qualify for new policy, they can be expected to do so & those that cna't will keep policies
      • conservation of deaths
        • A - portion of policies that lapse @ dur r to buy new policy @ x+r
        • A*q(x+r,t-r) + (1-A)q_AS(x,t) = q(x,t)
        • A(s) - portion of policies that lapse @ s to buy new @ x_s
        • q_AS(x,t) = [q(x,t) - sum(A(s)q(x+s,t-s))] / [1 - sum(A(s))] where sum are s=1 to t
    • Blending Tables
      • sometimes necessary to combine two tables to get a single blended table (ie Unisex)
      • usually better to blend survival table (lx) instead of mort tables (qx)
    • Adjusting Similar Experience
      • factors to consider if using similar experience b/c actual not credible
        • quality fo co u/w relative to experience underlying other experience
        • distribution channels - more antiselection in brokerage than career
        • anti-selectin from excessive lapses
        • u/w reqs for preferred or substd risk classes
        • reins quotes on the business
      • if need a table in a country where no study of insured lifes mortality exists
        • also consider
          • starting w/ general population mortality studies
          • quality of data
          • cause of death info
          • abiltiy to do medical u/w
          • ability to contest claims
          • liklihood of wars, epidemics, or natural disasters

• Stucture
  • generally by duration since policy issue
  • may also vary by
    • IA
    • freq of prem payment
    • policy size
    • plan type (term/WL/UL/annuity)
    • mktg method
    • market
    • for perm, 1st year usually higher than renewal
    • term and annuity - often shock lapse tied to product design
      • annuity - when SC expires
      • term - when level prem period ends
    • lapse rates often vary by scenario for CFT or option pricing b/c of different interest rates
      • expressed as a formula that adjusts base rate to reflect
        • delta mkt and credited rate
        • size of SC
    • Lapses assumed to occur on prem due dates
      • "lapse skew" might be appropriate depending on distribution of business
• Analyzing Experience
  • Credibility
    • generally less of an issue for lapses than for mort
    • generally less refined assumptions than for mort (helps w/ credibility of data)
    • lapse rates generally higher (helps w/ credibility of data)
    • confidence intervals - calced same as mort
  • Lapse Studies
    • mechanics same as mort - except lapses & deaths switch spots in calcing claims and exposures
  • Factors Affecting Lapse Rates
    • product design
    • policy size
    • dist channel - brokerage higher lapses than career due to shoping
    • effectivness of company conservation programs
    • if lapse rates expressed as formula that varies by int rate scenarios
      • significant judgement involved in setting parameters
      • sensitivity of lapse to int rate usually varys by
        • product type - DAs more sensitive than trad life
        • dist channel - stock broker business more sensitive than agent sold
  • Types of Lapses
    • usually include
      • termination w/o value b/c failure to pay prems
      • cash surrenders
      • transfers to ETI/RPU
    • others that depend on study or purpose of assumptions
      • term conversions
        • if term conv charges attributable to term policy, need a sep study
        • if cost absorbed by new policy, count as lapse
      • partial w/d - usually included in lapse rate unless product design has provision for free partial w/d
      • premium persistency - actual to target/billed from flex
      • termination w/o value b/c policy loan > CV

• Structure
  • deterministic models generally use one of two appraoches
    • portfolio avg
    • Inv generation method (IYM)
  • for IYM
    • fixed prem policies grouped by issue year
    • flex prem polices group prems by mo rec'd
  • nv income assumptions generally net (after expenses & defaults)
  • Policy loans can be asset CF or liab CF
    • for deterministic models - generally aggregated w/ other investments
      • therefore also need assumptions for
        • policy loan int rate
        • policy loan expenses
        • policy loan utilization rate
    • if model has multiple int rate scenarios, policy loans generally modeled as liab CF w/ utilization rate that varys by scenario
      • how many?
      • specified by client/regulation?
      • generated by stochastic model
      • # scenarios depends on relative importance of asset risk and practical concerns (such as model runtime)
      • for each scenario, int rates can vary by
        • time
        • asset class
        • asset quality
        • credit risk
    • Inv returns can be measured on a book ro mkt value basis
    • also need assumptions for
      • mix of existing assets by asset class and maturity
      • reinvestment and disinvestment strategy
• Analyzing Experience
  • int rate determined as inv income from block / avg assets in block
    • i = 2*I/(A+B-I)
  • for "new money" rate - usually some benchmark rate + spread
  • total returns on a mkt value basis - needs to realized and unrealized g/l
    • r = (B-A-C)/(A+C/2) - C is net cash flows, A&B - mkt values
  • mutual funds often calc daily and if assume that all CF @ end of day
    • r = (B-A)/A
  • if evaluating rates of return over time
    • time-weighted return - geometric mean of rates of return
    • dollar-weighted return - level rate of return earned taking into acct timing of CF

• Structure
  • generally split between direct (aka marginal) expenses and indirect expenses
  • certain expenses can be direct or indirect depending on model and purpose of model
  • also split between acq, maint and overhead
• Analyzing Experience
  • Units
    • unit expense assumption = expenses / # untis
    • experience study looks @ expenses by calendar year
    • pricing
      • policy year expenses
      • usually charge expenses @ either BOY, EOY or midYear
      • need appropriate unit count based on when expense is charged
        • expenses charged BOY -> count = (A+B+N)/2
          • midyr -> (A+B)/2
  • Expense ALlocation
    • important to understanc how co allocates expenses to LOB
    • some expenses clearly associated w/ particular product or LOB
    • other not so clearly - several methods to allocate
      • first need to split total expenses into major components
      • once categorized, allocate
        • transaction or item counts
        • transfer costs
        • employee time allocations
        • indexed based allocations (allocated by policy count or prems)
  • Projecting Expenses
    • future unit expenses depend on estimating of total level of expenses an dcount on which unit expenses based
    • projection shoudl reflect
      • historic trends
      • expected future volumes of business
      • expected inflation rates
      • how expenses vary w/ changes in business volume (fixed/varaible/step rate)
      • impact of any planned business changes

• insurers limit coverage at older ages
  • dis rates increase dramatically at older ages
  • hard to tell between dis and normal ret at older ages
• Calc of PV of benefits is a 2-step process
  • benefit provided at point of where dis occurs must be calced
    • benefit is a disabled life annuity = PV waived prems using int and rates of termination of dis
  • PV @ issue of each benefit is calces using int, active life mort and rates of dis
    • calced at each point dis can occur and summed
• calc of actual gross prem can be simplified by loading published valn net prem
  • loading determined by fitting adjusted experience prems to valn net prems

• Prems Waived
  • prems used in benefit calc s/b net cost to insurer of prems actually waived
  • consider
    • commissions paid on waived prems
    • prem taxes not paid on waived prems
    • if offered, sex-distinct prems s/b used
    • if prems vary by size of policy, either
      • avg size s/b used or
      • sep prems calced for each band
    • YRT - S&U - simplified by calcing single AA table based on ultimates
    • Term Conversions - should use permanent plan's premium in calc
    • if prems vary by s/ns - blended rates or sep prems
• Interest
  • significant impact b/c long dur benefit
  • conservative LT rate s/b used
• Expenses
  • cost of initial and ongoing claims investigation
  • acctg for waived prems
  • reserving for coverage
  • command prem tax on premium for benefit
  • some cos charge share of overhead
• Active Life Mortality
  • used to determine survivorship for non-disabled lives for
    • PV (@ issue) of benefits
    • annuities used to calc net ann prem
  • use same experience assumption used for pricing base coverage
  • table of commutation functions D([x]+k) = v^(x+k)*l([x]+k)
• Lapse Rates
  • conservative to assume no lapses
  • use base contract rates if using any
• Morbidity
  • Rates of Disablement - measure chance of life aged (x) becoming disabled at age (x+k) (and remaining alive and disabled to end of waiting period)
    • probability of disablement - r(x+k)
    • absolute annual rate of disablement - r'(x+k)
  • Rates of Termination of Disability
    • needed to calc dis life annuity values
    • measure probability of leaving the group of disabled lives (from recovery or death)
    • highly select by duration since disablement
      • usually monthly for first 2 years
    • very few people beyond retirement age recover from disabled status
    • Termination rates used to construct table for dis lives
    • l_i([x+k]+m/12+s)
      • k+1 - year disablement occurs
      • m - months in waiting period
      • s - duratoin since end of waiting period
    • D_i([x+k]+m/12+s) = v^(x+k+m/12+s)*l_i([x+k]+m/12+s)

• Assume
  • disabilities occur mid policy year
  • prem and benefit payments payable continuously throughout policy year
  • waiting period is 6 months
• B(k+1) - benefit provided if dis occurs in year k+1
• P(k) - prem/14m payable during k+1
• u = age wvr benefits end
• h - prem paying period of base plan
• n - cvoerage period for waiver provisoin = min(h,u-x)
• h' - prem paying period for waiver provision
• B(k+1) = sum(P(k+s+1)*(D_bar_i([x+k+1/2]+1/2+s) / D([x+k+1/2]+1/2))) from s=0 to n-k-2
  • if P is level = P*abar_i([x+k+1/2]+1/2:n-k-1|)
• if coverage retroactive, B(k+1) increased by half prem payable in k+1 (0.5*P(k))
• PVB = B(k+1)*v^(x+k+1)*l([x]+k+1/2*r'(x+k) / D([x])
  • = B(k+1)*v^(1/2)*r'(x+k)*D([x]+k+1/2) / D([x])
• NWSP = sum(PVB) from k = 0 to n-1 -> net waiver single premium
• NAWP = NWSP / active life annuity
  • = sum(B(k+1)*v^(1/2)*r'(x+k)*D([x]+k+1/2)) / sum(D_bar([x]+k)) for (numerator) k = 0 to n-1 and (den) k=0 to h'-1
• To load for expenses
  • E_wp(pi) - exp prem, loaded for expenses
  • B'(k+1) - expense loaded benefit if dis in k+1
  • c(k) = active life % prem expense in k+1
  • e(i) - active life per pol expense in k+1
  • c_i(s+1) - dis life % benefit expenses paying in dis year s+1
  • e_i(s+1) - dis life per pol expense in s+1
  • assuming per pol expenses paid @ BOY and % expenses paid continuously
  • B'(k+1) = .5*P(k) + sum{[P(k+s+1)*(1+c_i(s+1)) + e_i(s+1)]*[D_bar_i([x+k+1/2]+1/2+s)/D_bar_i([x+k+1/2])]} for s = 0 to n-k-2
  • E_wp(pi) = sum{[e(k)*D([x]+k) + B'(k+1)*v^(1/2)*r'(x+k)*D([x]+k+1/2)]} / sum{(1-c(k))*D_bar([x]+k)} for (num) k=0 to n-1 and (den) k=0 to h'-1

• substandard risks
  • waiver usually restricted to least substd risks
  • waiver prems usually multiples of std business wvr prems
• Payor Benefit
  • waives premiums if payor of juvenile policy is death/dis until juv attaines 21/25
  • prems depend on age of applicant, plan of ins, age of insured
  • gross prems usually published at table of factors
• Riders on Insured Spouse or Children
  • waives rider prems
  • based on base insured, not spouse or children
• Non-traditional Products
  • indeterminate prem products
    • using guar prems in calc is conservative
      • might be uncompetitive
    • use judgement re: most likely scale of prems to be charged and use in calcs
  • UL
    • waiver of coi
    • specified amt - use specified amt in formulas and is aount req'd to keep contract in force if all guarantees realized
      • does not have any relationship to prms actually paid into contract
    • either case, use same formulas, just different P(k) stream

• generous min DB designs, harder to understand risks in providing MGDB
• benefit costs little (if anything) usually
  • could be very costly in certain events
• Monte Carlo approach
  • large # scenarios b/c > 1/2 trials result in 0 or minimal cost
    • but very long tail (sd > mean typically)
  • results similar (but slightly higher) than B-S approach
• first tests using 3.75% base return assumption
  • historical returns consistenly above that.
  • author uses 8% remainder of note
• cost of MGDB drops drastically as assumed yield increases
• base return assumption is a CRITICAL ASSUMPTION
• distribution has large kurtosis
  • large number of outliers
  • sd > mean demonstrated volatility of results

• approach pricing through an asset charge
  • problem - charge collected over longer time frame than claims
    • creates reserving problem and insurer exposed to lapse risk
  • one approach - study point in each scenario where insurer is in worst position
    • if distribution of results is unsatisfactory, try again w/ higher/lower asset charge

• enhanced DB provisions included in many contracts
• "Ratchet 5 to 70" increases (never decreases) min DB on every 5th anniv to then current policy value (if it is higher than prior min db)
  • no increases after age 70
• "Increase 5% to 200%" - prems accumulated at 5% subject to 200% max, no age limit
• "combined to age 70" - combines ratcheted formula w/ int formulat - greatere DB under either formula, but no increases after 70
• enhanced formulas add signficantly to cost

• resets are most important cost factor
• frequency of reset also significant cost factor

• actual costs highly sensitive to
  • base underlying yield assumption
  • issue age
  • mkt volatility
  • lapse rate
  • benfit provisions

• B-S easily produces sensible, quick calcs of values for min DB for simpler cases
  • complex for ratcheted formulas
• Monte Carlo - requires many trials, but easy enough w/ current spreadsheets

• based on 10 year term (level prem)
• generally experienced more insureds qualifying for pref non-smoker risk class than expected
  • less qualifying for pref smoker than expected
• not takes generally lowest for most restrictive pref ns and highest for least restrictive std smoker
• most freq used risk criteria
  • personal history
    • diabetes
    • heart disease
    • cancer
    • elevated cholesterol
  • Lifestyle criteria
    • alcohol and other substance abuse
• some allow exceptoins to pref risk criteria
  • blood pressure and build
  • family history
  • slight variations in one criteria
  • cholesterol level
• majority of respondents use captive or independent agents to sell pref risk products

• pref risk class - risk class w/ better expected mortality from gruop of non-substd applicants
• std class - residual non-substd applicants
• pref risk class if very varied, even w/in same co
  • varys between products and even generations of same product
• established by splitting an aggregate risk class into two or more risk classes
• common formulas
  • q_pref = (1-discount)*q_agg
  • q_std = [q_agg - q_pref*%qualifying]/[1 - %qualifying]
• two critical assumptions - based on pref u/w criteria chosen
  • what discount to give to pref u/w class
    • consider
      • agg mort used
      • screening tools used
      • strictness and level of criteria used to qualify for pref risk class
      • co's practices on u/w exceptions
      • % of applicants desired to qualify for pref risk class
    • stricter u/w -> better discount
    • usually 10-20% range
  • % expected to qualify
    • normally cos determine this and adjust u/w criteria to make it happen
    • the lower the assumption, the more aggessive the discount can be
      • more applicant & producer dissatisfaction w/ lower assumption
      • additional pressure on U/W to make exceptions
      • possibly higher than expected not-taken rate
    • important for actuarial/u/w/mktg to be involved and understand
    • # applicant for pref class (initially) may be higher than expected b/c producers tent to bring better risks forward
    • % placed in pref class initially exceeds expectations as well for same reason and higher not-takens
    • other reasons for getting disproportionate share of pref or std risk class
      • producer's client base
      • specific criterion much different from what other cos use
      • u/w concessions
      • unreasonable initial expectations
  • Why have new risk classed developed
    • legitimate descrimination
    • equity considerations
    • mktg tool <- main reason
      • most often developed for competitive reasons and/or defensive purposes

• Risk Classes
  • trend toward using more pref risk classes
• Percentage Expected to Qualify adn Percentage Actually Issued by Risk Class
  • on avg, more policies issued in most restricive NS class than originally expected to qualify
    • slightly less policies in most restrictive smoker class than originally expected to qualify
  • if actual results appreciably different from expected, maybe investigate reasons
  • possible explanations:
    • agent selection
    • improper initial assumptions
    • u/w exceptions which allow more issues in pref risk class
    • not takens in std risk class (which distorts the % placed in pref risk class)
• Not Taken Rates
  • most restrictive NS (5%) < agg smokers < most ristrictive smoker < least restrictive NS < least restrictive smoker (24%)
  • applicants dissatisfied w/ risk class may look elsewhere for better rating
• Expected Mortality
  • in general, pref risks had decreased expected from prev study
  • possible reasons
    • tighter pref u/w
    • shift from NS to NT
    • better than expected early dur experience
    • competitive mkt pressures
• Ratio of Std To Pref Mort
  • approx 130-135%
• Max IA and Min Face Amt Limits
  • usually around 70/75 for pref class
  • min face usually 100,000 for pref class
• Age and Face Amt for U/W req
  • features that influence what reqs used
    • company's mkt
    • distribution system
    • specific criteria that must be met to qualify on a pref risk class basis
    • mortality expectations
    • competitive environment
    • u/w philosophy and expertise
    • other fin objectives
• Common Reqs
  • Blood Profile $100k+ sometimes lower over 20 tests
  • DBS infrequent
  • Oral Fluid (OFT) infrequent can test for HIV, continine and cocaine
  • Urine $100k+ usually in combo w/ blood - tests fro continine, cocaine, diabetes, kidney probs
  • Cotinine $100k+ as part of urine or OFT
  • Cocaine $100k+ as part of urine of OFT
  • Illegal drugs infrequent
  • NonMed <$100k limits increasing w/ PHI, MVR adn agent collected fluids
  • ParaMed $100k+ & older ages
  • Medical $500k+ & older ages
  • APS older ages adn $500k
  • MVR about half $100k+
  • ECG older ages
  • PSA about half older ages
  • HIV $100k and about half < 100k
• Collection of Fluids
  • considerations when using other than paramed or med to collect
    • legal liability
    • chain of custody considerations
    • confidence in quality of test results
    • producer/consumer reaction
  • must weigh cost savings against these issues
• Indicators Being Used as Preferred Risk Criteria
  • Three broad categories of application info
    • personal history
    • family history
    • lifestyle considerations
  • some important info is verified independently from app
    • ex. from DMV
  • sometimes favorable info could offset unfavorable
  • personal history considered more important than family history
  • personal history and lifestyle most freq used criteria
• Personal History
  • except for cholesterol, at least half cos preclude applicant from qualifying for pref risk class for bad info on personal history
  • diabetes/heart disease/high cholesterol/non-skin cancer/stroke/hypertension/melanoma/treatment for hypertension/mental-nervous/non-melanoma skin cancer/treatment for cholesterol/prescription drugs
• Family History
  • heart disease/cancer/stroke/diabetes/hypertension/non-accidental early death
  • heart disease is only family history that is an automatic preclude - approx 1/2 cos
  • most base family history on occurence of death, not diag
  • other factors
    • whether natural parents or natural parents & siblings included
    • # incidences of death or diagnosis allowed
    • age limit for incident of death or diag
    • offsetting family history w/ good applicant health or neg stress test in last year
    • using gender specific cancers only
• Lifestyle
  • MVR and body fluids verify lifestyle items
  • if declined, will reconsider after they discontinue adverse activity for period of time
  • alcohol abuse/illegal drugs/driving/DUI/aviatoin/avocation/hazardous sports/other tobacco/cigarettes/occupation/foreign residence/foreign travel/felony conviction/regular excercise
  • all but exercise used regularly
  • drug and alcohol abuse were automatic out
• Driving Record and DUI
  • normally no more than 2 or 3 moving violations in 3 year peroid
  • no DUI w/in last 3-5 years
• Cigarette and other tobacco use
  • usually no usage in last 12-36 mo
• Differences in Criteria by Smoking Status
  • rarely - blood pressure, build & cholesterol
• Diff in criteria by gender
  • rarely - build
• Other criteria use to Determine Pref
  • Std Med risk
• Ranges of Criteria in Use (to qualify for Pref)
  • total cholesterol - usually around 250 (220/240/250)
  • Total Cholesterol/HDL-C ratio - 5.0/5.5/6.0
  • GGT (tests for liver damage) - 65 units/liter
  • SGOT (myocardial infarction/hepatitis) - 40/41 units/ml
  • SGPT (liver enzyme - hepatitis) - 45 units/ml
  • PSA (prostate) - 4.0 ng/ml
• Preclusion from Pref Risk Class due to lab test result
  • approx 2/3 based on Tot-C/HDL-C
  • < 1/2 on other criteria
• Blood Pressure
  • considered a coronary risk factor - 140/90 as max untreated BP
  • about 1/3 preclude individuals w/ treated hypertension
  • remaining allow treated BP in range
• Height and Weight
  • approx 1/2 do not automatically exclude if out of range
• Debits
  • ome co's don't allow credits for pref u/w, some do
  • max debits usually <= 25 (after credits)
  • most <= 50 before credits
• U/W guidelines for Exceptions
  • approx 1/4 ahve written guidelines for exceptions
  • virtually all cos allow u/w judgement to pref qualification
• Exceptoins to Pref Criteria
  • most allow exception if overall risk profile would still qualify for pref risk class
• Additional Comments
  • one co has agent "IOUs" baed on production
    • can be redeemed to reduce prem rating by up to 2 tables
• Dist Channels
  • must used indepenant agents and captive agents
  • about half use multiple dist channels
• Effect of Introduction of Pref Risk Class
  • approx 2/3 saw increased production
  • caveat - toher factors couls also affect sales
• Illustration Restrictions on Pref Risk Classes
  • virtually all allow best class to be illustrated
    • some discourage illustrating initially
    • other allow, but must also illustrate on std class at same time
  • some require field u/w assessment before allowing pref illustration
• Application for Pref Risk Class
  • approx 10% require applicant to apply for best class to receive it
• Pref Risk Classes on OTher Products
  • most cos w/ pref class have it on products in addition to 10yr Term
• Review of Pref Risk Criteria
  • how often to review
  • approx 1/2 review at least annually
• Future Changes in Pref Criteria
  • approx 15% had plans to change pref criteria
  • > 1/2 no plans
  • rest didn't know

Valuation and Financial Statements

• principle liablilities of a LIC are due to contingent benfits granted on its long term policies and contracts
• small cahnge if value can have significant impact on co's earnings
• reserves - liablilities for amts inc co is boligate to pay in accordance w/ policy
• amts usually uncertain or contingent as to exact amt and/or time of payment
• some reserves for incurred but unknown to ins co - claim (or loss) reserves
• some reserves for event not yet happened but ins co obligated to pay - policy reserves
• actuarial reserves = policy reserves (as far as text is concerned)
• actuarial valuation - process of determining actuarial reserves
• theory behind reserves (law of large numbers) only true for blocks of policies, not at the indiv policy level

• Statutory Valuations
  • used to help regulators assess financial health of the company
  • conservative assumptions since emphasis on solvency
  • in US - assumptions and methodology very explicit in the law
  • US rules based on old practical decisons made in pre-computer era
  • trend toward more than just "cookbook" - need to ensure liabilities good and sufficient
• GAAP Valuations
  • required if stock is publicly traded or owned by a apublicly traded co
  • objective: accurate allocation of income to period earned
  • assumptions required to be reasonable and conservative, not as conservative as stat
  • Canada - GAAP = Stat (using PPM)
  • incorporates explicit lapse/surrender assumptions
• Gross Premium Valuations
  • used to produce "best estimate" value of co's liabilities
  • less conservative than GAAP
  • may be appropriate to determin co value for acquisition/merger
  • incorporates explicit lapse assumption
  • PV future gross prems - PV future benefits
  • PPM is a gross prem valn
  • value-added financial measurement - offshoot of GP Valn
    • uses stat reserves, but future values of stat profits recognized in valn
• Tax Reserve Valuations
  • used to calc reserves for determing taxable income
  • Canada - 1.5 yr FPT w/ csv floor
    • may be > or < statement Vx
  • US - 1958-1984 based on stat Vx w/ adjustments
    • 1984+ - FPTR (Fed Prescribed Tax Reserves)

• Gross Premium Levels
  • indirectly affect since guar prems typically set at level to avoid def reserves
  • take into account cost of capital required
• Product Design
  • guar rates to avoid def reserves
  • avoid product features too difficult to reerve
  • int guarantees on annuities affected by CARVM
• FIT
  • FPTR make it fairly insensitive to Stat
  • if unspecified in tax code - follow stat practices
  • Tax Vx <= Stat Vx
• Divs to PO
  • if div formula uses Stat Vx, significant impact
  • if doesn't use Stat Vx, still probably uses some stat info to allocate surplus
• Stat Earnings
  • obvious - stat Vx affects Stat earnings
  • US: divs to stockholders limited to accum stat earnings of Co
• Important Indicators
  • several industry measures are based on Stat Financial Measures (like rating agencies)
• Other Considerations
  • pricing profit objectives might be accum surplus / stat Vx > y% at year z
  • reserving methods do not directly affect total profitability of a product, only emergence of profit by year (pre-tax)

• 3 major components - math calc, verification of results, actuarial opinion
• Mathematical Calculations
  • PV of excess of future benefits over future premiums
  • based on assumptions for lapses, mortality, interest, etc
• Verification of Results
  • demonstration that assumptions are reasonable
  • interest given more scrutiny o flate
  • structure of assets need to be viewed together w/ structure of liab
• Actuarial Opinion
  • qualified actuary signs opinion re: appropriatness of Vx

• SVL
• Opinion shoudl list items and amounts for which expressing an opinion
• OK to have sep opinions for separate blocks
• indicated reliance on others
• requires an actuarial analysis of reserve and assets supporting reserves
• Opinion as to Non-Guaranteed Elements
  • includes contracts such as (if they contain non-guar elements)
    • single and periodic premium DAs
    • UL contracts w/ fixed and/or flex prems
    • indeterminate premium life contracts
    • single and periodic premium ilfe contracts
    • ren and conv term ins contract which do not guar the prems payable on renewal or which provide fo rrenewal on teh then current basis
  • if contract ahs charges or benefits which vary at co discretion (excl divs and sep acct based contracts) then A.S. aslo needs
    • statement containing determination procedure for non-guar elements
    • 8 interrogatories dealing w/ determination of non-guar elements, supportibility and relationship of current non-guar elements to those used in sales illustrations
    • actuarial opinion related to non-guar elements signed by a MAAA
• RBC Requirements
  • Four components
    • Asset quality and payment default risk
    • Insurance Risk (pricing)
    • Interest Rate risk (disintermediation, reinvestment)
    • Business risk
  • represents "minimum" capital and surplus level for a particular co

• big gap here since 8I-U and not 8I-C

• determined as of policy issue date by state valn laws then in effect
• most state laws based on SVL
• min Vx defined in terms of net prem valn
• defines minimum standards of mortality and interest
• 1980 amendments - dynamic valn int rate - allows automatic adjustments to int rate changes

• Valn Mortality
  • Pre-80 SVL Amendments
    • AA mortality tables w/ setbacks for females
  • 80 SVL Amendments
    • adopted 80 CSO table
    • had to choose from
      • 80 CSO M/F
      • smoker/ns versions of both 80 CSO M/F
      • Unisex 80CSO
      • Unisex S/NS 80 CSO
      • ANB/ALB
      • 10/15 year select factors
    • all states allow unisex for nonf
    • some states require M/F for valn
• Int Rates
  • 1947-1974 most states used 3.5% for all classes
  • max was a problem as investment rates increased
  • rates were increased
  • 80 amendments - changed to dynamic max valn rate - linked to Moody's Corp
    • resulted in rates that ary by duration of contract guarantees

• NLP Reserve Method
  • designed to cover benefits only
  • no explicit recognition of any expenses is made
  • for a plan/issue age, net prem = constant % of gross prem
  • sum(k*GP(t)v^(t-1)*l(x+t-1)/l(x)) = sum(DB(t)v^t*d(x+t-)/l(x))
  • NP(t) = k*GP(t)
  • if WL then NP = P(x) = A(x)/adue(x)
  • typically produces highest Vx
  • typically requires significant V(1) therefore avoided by surplus conscious cos
• Expense Allowances
  • used to reflect large first year expenses intended to be recovered from future margins
  • Modified Reserves - basically NL reserves less an unamortized expense allowance
    • note:DAC is essentially an expense allowance
    • EA = beta_mod(x) - alpha_mod(x)
      • beta_mod(x) = renewal net premium for modified Vx method
      • alpha_mod(x) - 1st year net premium
      • V_mod = V_nl - EA*adue(x+t)/adue(x)
    • FPT Reserves - 1st year net prem = 1 year term net prem & renewal net prem = NLP for remaining coverage @ IA + 1
      • for WL, EA = A(x+1)/adue(x+1) - c(x) (c(x) = A'(x:1|) results is V(1) = 0
    • for stat valuations, expense allowance is limited to a max
    • expense allowance is formula based and not limited by actual first year expenses incurred
• CRVM
  • FPT reserves if FPT adj NP < 20 pay life adj FPT prems
    • else 19P(x+1)-c(x)
  • if DB non-level, then DB = AvgDB(2-10) per AG17
    • valn NP for years 2+ are constant % (k) of gross prems
  • sum(k*GP(t)v^(t-1)l(x+t-1)/l(x)) = sum[t=1](DB(t)v^td(x+t-1)/l(x)) + 19P(x+1) - DB(1)c(x) (P_FPT > 19P(x+1))
  • sum(k*GP(t)v^(t-1)l(x+t-1)/l(x)) = sum[t=2](DB(t)v^td(x+t-1)/l(x)) (P_FPT <= 19P(x+1))
  • AG21 - if beta - alpha < 0, excess to be taken as 0
  • AG25 - COLA policies to be reserved w/ increases = i_valn - contanst based on type of guarantee
  • CRMV produces 0 V(1) from most policies which helps surplus strain on NB
• Other Methods
  • Grade from CRVM to NL after x years (typically 20 years)
    • reason: to offer products w/ higher (than min) 20yr CV by < Vx
    • (P_G - P_NL)*adue(x+1:19|) = EA_CRVM*adue(x+1)/adue(x)
  • in general, NL reserve method defined by magnitude of EA and period over which it is amortized
• Other Alternatives
  • Arguments for a change to SVL
    • based on artificial, predetermined i, fixed for life of contract
    • embedded conservatism deliberately adds a solvency margin ~ volume business transacted
      • this is in addition to RBC
    • several insolvencies illustrate weaknesses in current system

• < 1978 - similar to US
• 1978-1991 - Valn Actuary - modified NP
• PPM - expenses treated explicitly therefore gross prem valn
  • PADS

• Mean Reserves
  • Interpolated Mean Reserve - (1-h)([t-1]V(x) + [t]P(x)) + h*[t]V(x)
  • Mean Reserve h = 1/2 -> [t]MV(x) = 0.5*([t-1]V(x) + P(x) + [t]V(x))
• Deferred Premiums
  • modal premiums due after valn date & befroe next policy anniv
  • an Asset in US (neg liab in Canada)
    • b/c mean reserves based on annual net prem payment @ boy overstate reserves on policies w/ more freq modes of payment
    • use net prems since reserves based on net prem
    • usually calced using an inventory
    • can use avg def premium (m-)/2m * P(x)
    • using avg def prem, net liab = 0.5*([t-1]V(x) + [t]V(x)) + 1/2m*P(x) (mean reserve - net def prem)
• Mid-Terminal Reseres and Unearned Premiums
  • interpolated terminal reserve (1-h)[t-1]V(x) + h*[t]V(x)
  • mid-terminal reserve 0.5([t-1]V(x) + [t]V(x))
  • used by some companies instead of mean reserves
  • understates reserves unles sprems paid very frequently
  • Unearned Premium Liablility - used as an adjustmetn
  • usual practice - 1/2 modal prm for each policy
  • can also calc exact for each policy
  • or estimate as 1/2m * P(x)
  • net liability is saem as formula shown under def prems

• show start-step of modal premium reserves

• Curtate and SemiContinuous Factors
  • reserve formulas assume prems payable at BOY and claims paid at EOY
  • reality: prems paid modally and claims paid at death
  • Immediate Payment of CLaims Reserve (IPC)
    • AG32 - need to establish IPC reserve if basic reserves calculated using curtate functin
      • IPC reserve = i/2*death portion of basic reserve (term portion if an endowment) if policy credits interest from DOD to date of payment
        • i/3 if payment made immediately upon receipt of due proof of death
        • 0 if payments made @ EOY or Vx calculated using continuous or semi-cont or disc cont
      • Semi-Continuous Reserves - prems payable @ BOY, claims paid at moment of death
        • P(Abar(x)) = Abar(x)/adue(x) [t]V(Abar(x)) = Abar(x+t) - P(Abar(x))*adue(x+t)
• Fully Continuous and Discounted Continuous Factors
  • Fully Continuous - continuous prems adn IPC
  • Discounted Continuous - prems paid BOY, IPC and refund of unearned portion of Px @ death
    • two net prems - one for terminal reserves and one for mean reserves
  • discounted continuous is what most cos using "continuous" actually use
  • difference between fully continuous and dicounted continuous
    • fully cont based on NP payable continuously throughout the year
    • reserve factors are mid-terminals adn unearned prem reserve must be set up for prems paid beyond valn date
    • disc cont terminal reserves = full continuous terminals
    • mean reserves calculated using annual NP = continuous NP discounted w/ int only
    • def prem reserve calculated if mode <> annual
• Relationship of the Expense Allowance to type of Reserve Factor
  • NP under semi-cont and cont methods > curtate
  • SOA published tables using abar(1|)*Pbar(Abar(x)) + (P(x+1) - c(x))/adue(x) <- cont renewal prem for WL
  • theoretically correct s/b abar(1|)*Pbar(Abar(x+1)) <- s/b used per AG18
• Nondeduction Reserve
  • under curate or semi-cont - assumes full annual premium collected each year
    • not true since std practice is to not collect modals due after death
  • reserve for this -> term insurance for avg # remaining def prems @ date of death
    • for endowment, this woudl be[t]V'(x:n|)*((m-1)/2m * P_modal(x:n|))
• Refund Reserve
  • many cos refund pro-rata share of prems for periods beyond DOD
  • reserve for both this and non-ded reserve -> 0.5*P_modal(x:n|)*[t]V'(x:n|)
    • where P_modal(x:n|) approx = P(x:n|) / (1 = (m-1)/2m*d - 0.5P(x:n|))
    • co's often omit (m-1)*d/2m term so 1 factor applies regardless of mode
  • these reserves not necessary for fully and discounted coint reserves - already built in
  • nice grid goes here showing various reserve components for curtate, fully, disc and semi cont

• policies develop CSV based on retrospective accum of (flex) prems less mort and expense charges at a declared or indexed rate
• this makes them not compatible w/ trad valn procedures

• premiums less expense charges credited to fund
• int credits credited to fund
• mort and expense charges deducted from fund
• CSV = fund value - SC
• Minimum Reserves
  • 1983 - NAIC rules - to make UL work w/ trad valn formulas
    • GMP - guaranteed maturity premium - level gross premium that provides for an endowment at the latest possible maturity date
      • calculated at issue using policy guarantees for expesne and mortality charges adn int credits
    • GMF - guaranteed maturity fund - calced as of issued date assuming GMPs are paid
    • r = min(actual fund value / GMF, 1)
    • policy fund projected forward using max(GMF, Actual Fund Value) assuming GMPs paid
      • this produces guaranteed DBs and Guar Maturity benefit for valn purposes
      • PV of these benefits calced on the valn basis
    • NL reserve = r*(PV projected DB - PV projected GMPs) (assuming GMPs paid from issue (not valn))
    • CRVM reserve = NL Reserve - r*unamort CRVM allowance for plan of ins generated at issue on guar basis assuming GMPs paid
  • Simplified: Model Reg assumes all UL plans are permanent plans @ issue
  • "r" factor to measure if policy is "on track" as permanent plan
  • if CV > Vx, excess held elsewhere on statement (was 8G)
• Alternative Minimum Reserves (AMR)
  • may be req'd if GMP < valn net premiums
  • if req'd - max(a,b)
    • a - reserve calculated using reserve method, mort basis and valn i actually used for policy
    • b - reserve calced usnig reserve method actually used, but using min stds of mort and i allowable for V_def(x) & replacing valn net prem w/ GMP
  • valn net prem (VNP) not explicity defined in model reg
  • most cos interpret VNP = P_NL + EA/adue
  • Features that lead to AMR
    • no load products if guar COI and i similar to valn basis
    • Guar COIs < valn mort (esp if i_guar = i_valn adn low/no fe loads)
    • i_guar > i_valn
    • any product features that lower GMPs
• Examples
  • [t]V_NL = r*(PVFB(t) - P_NL*adue(x+t)
    • PVFB(t) - PV based on project of policy funds using policy guarantees where initial value is max(actual fund, GMF)
  • for CRVM - [t]V_NL reduced by r*EA_CRVM*adue(x+t)/adue(x)
  • for monthly pay policies, DB incr monthly, for PV, use avg annual DB and continuous commutatoin functions

• key difference for fixed vs flexible premium
  • GMP = gross prem
  • EA adn rate of amort determined by plan of ins guaranteeed at issue
  • r = 1
• to calc CRVM
  • project future benefits on guar basis - take secondary guar into acct
  • value benefits using valn mort and int
  • subtract PV cuture CRVM net prems for plan of ins guar at issue

• provides teh PO a guar set of CVs, DB and/or mat benefits regardless of fund performance
• 1995 valn model reg - if secondary guarantee keeps policy in force 5+ years, reserves = form implied by secondary guar

• UL Model Reg defined terminal , but not off-anniv
• issues
  • r - should it be as of valn date, prior or next anniv
  • how to calc GMF on valn date if r is calced on valn date
  • use first priciples or mean/mid-terminal/interpolated reserve
• generally considered appropriate to calc r as of valn date
• use annual GMPs or GMPs consistent w/ planned prem mode? - be consistent w/ reserve method used
• advantage if using first principles - avoid net def and unearned prems

• some resistance to change since UL tax reserves defined in terms of existnig UL Model Reg (UL-CRVM)
  • if change, might need to calc using 2 different methods into the future
• Guaranteed Maturity Premium Method (GMP Method)
  • Calc GMP, GMF, r
  • [t]V_GMP = r*[t]V_CRVM where [t]V_CRVM is reserve for traditional CRVM based product (perm ins w/ mat date = latest possible date under UL plan)
  • if Fund(t) <= GMF(t) then (above)
  • else [t]V_GMP = [t]V_CRVM + Fund(t) - GMF(t) (if Fund(t) > GMF(t))
  • if r < 1, this generates save value as model reg
  • if r > 1, felt this is a reasonable approx for most products
• California Method (1991 for 1992+ issues)
  • simmilar to UL model reg exept valn i <= credited rate guar in contract or alt reserve = mean(CV,fund value)
• NY147 (1994) - allows CA method as elective alt basis for UL reserves
• SVL - reserves >= min aggregate amt req'd by state statement if filed, therefore if filing in CA, need to test for this
  • even if use CA reserve, need model reg calc for tax reserves

• using CV as reserve for flex prem UL can effectively defer losses to later years
• CV can become > CRVM reserves once SC wear off
• renewal losses can occurr when CV increases not supportable by the gross prem
• this would fall under unusal CSV provision of Model Reg of Trad, but UL is specifically exempt

• Commissioners Annuity Reserve Valuation Method (CARVM) - 1976 amendments
  • Vx = greatest excess of PV @ valn date of future guar benefits @ end of each contract year over PV future considerations from future gross considerations
  • many companies slow to adopt CARVM and held more conservative reserves
  • tax law changed to say use CARVM as methodology for FPTR
    • cos forced to implement at that point

• project fund balcne forward at guar basis in policy, then calc all future benfits guar under policy
• take PV of all these possible benefit streams
• subtract out PV required considerations
• considered a "worst case" valn method
• ususually possible to determine which benefit produces the greatest PV eliminating most paths
• accumulation phase uses policy guarantees
• how to determine which dur will produce largest PV (for SPDA)
  • if guar annuity purchase rates less liberal thatn valn basis and CSV used to calc guar annuity payments, future guar annuity payments will never be used in CARVM b/c PV(future annuity pmts) < CV @ annuitization
  • if contract has no SC, guar fund accum rate < i_valn, then CV @ valn date is largest CV
  • if contract has no SC, guar fund accum rate > i_valn for n years after valn, CV @ last year i_guar > i_valn
  • if contract has no SC, guar fund accum rate always > i_valn , CV @ latest mat date
  • if SC, combined effect of i_guar & reduction in SC > i_valn for n years, CV @ end of year n
• if this is ignored @ product design, might have to do complete CARVM w/ each valn
• Mid-Policy Year Values and Continuous CARVM
  • projecting 1 more day causes cash values to jump b/c of SC changing day after valn
  • CARVM specifically state EOY
  • NY reg states any point during year aka Continuous CARVM
  • other states now following NY example

• Contingent Benefits (not elected by annuitant)
  • Death Benefits in Excess of CSV
    • such as SC waived at death or min DB = sum(prems paid)
    • AG33 - each benefit be considered in calc of CARVM Vx
    • in practice - DB reserve calsed as an add-on as PV excess DB over CSV
    • common approx - mort Vx = sum(PV(DB-CSV)) @ valn int and mort
    • more exact - only do above calc to policy year w/ largest CARVM reserve
  • Nursing Home Waiver
    • SC waived if annuitant enters nursing home
    • reserved similar to DV but using q_nursinghome instead of q_valn
• Bailout Provisions
  • surrender charge waived if i_credited fall more than a specified amt below initial rate
  • if bailout provision is in effect, SC s/b ignored for CARVM
  • AG13 - 1985 - can't include "significant" contingent SC in CARVM calc
  • NY126 - Vx if contract as significant SC = max(a,d) where
    • a = fund @ valn w/o SC
    • b = CARVM reserve w/o SC
  • "signficant" SC - SC% > i_guar
• Market Value Adjustments (MVAs)
  • MVAs expressed as formulas
  • questions
    • should MVAs be include in CV calc @ valn if operable
    • possible future MVAs, shoudl they be taken into account
  • if assets in general account, ignore MVAs in CARVM calc since GA assets not revalued under SAP
  • Modified Guar Annuity Reg - MVA annuity assets s/b in sep account
    • min Vx - CSV including MVA effect
    • NY127 has specific definitions
      • max(a,b) where a = CSV @ valn including MVA and b = PV guar contract benefits
        • where PV(b) - i =
          • annual mkt yeild S/A assets - inv expenses - 2.5% for junk - 0.25% PADs
          • Moody's Corp Bond Yield Avg (month - 1)
      • if assets held at book, max(a,b) where
        • a = CSV @ valn excluding MVA and b = PV guaranteed benefits assuming "B" type contract
• Free Partial Withdrawals (FPWs)
  • PO can w/d % of fund w/o SC
  • sometimes limited to x days after anniversary
  • need to reflect this free % in actual SC
  • for valn, two approaches
    • aggregate - adjust SC% (ie 5% SC adjusted to 5.0% - 0.5%free = 4.5%)
    • seriatim - test each and every partial w/d that could be made
  • some state ins depts have taken issue w/ aggregate approach and require seriatim
• Annuity Purchase Rates
  • often purchase rate incentives to encourage annuitization
  • purchase rates more favorable than guarantees
    • typically use current rates which are more favorable than guarantees
    • discontinuities in CARVM reserve
    • AG33 - if co guarantees that PO can annuitize @ then current rates, then CARVM Vx >= 93% of contracts fund value @ valn
  • waiver of SC
    • take into account when valuing
    • often limited to 10 yr+ options
  • two-tiered interest credits
    • one fund for nonf values and DB
    • one for for annuitization (and possibly DB)
    • second fund typically has higher int rate
    • first fund used for CARVM CVs
    • second fund for CARVM annuity purchase funds
    • if 93% rule in effect, then it is used against second fund
• Interest Index
  • if indexed - NAIC Int-indexed Model Reg says
    • future int crediting rates = stat int rate for contracts defined in SVL
    • if actuarial opinion not filed, a 115% rule is in effect
  • reg not adopted by all states
  • most cos ignore indexing unless in effect @ valn
    • except to extent CFT indicated need for additional reserves

• Calendar Year Valuations
  • same basic principles apply
  • even though cal year, fund balances need to be accum to end of policy year
  • some co's calc CARVM @ end of next policy year and discount back
• Current Cash Values
  • NAIC blank requires max(CV, CARVM Vx)
  • even though CARVM doesnt specify off anniv CVs, it is necessary b/c of this
  • when comparing CV vx CARVM, CARVM needs to include any DB reserve
• Grouping Methods
  • common and accepted to calc Vx on a group basis (vs seriatim)
  • assume groups of policies occur mid-year (unless known skewing)
  • SVL says OK
  • may not be appropriate for two-tiered or toher complicated product designs
• Change-in-fund Valuation Basis
  • SVL allows either issue-year or change-in-fund basis for PVFB calc
  • issue year basis - i_valn determined based on issue date of policy
  • change-in-fund basis - different discount rate depending on when increase in funds occured. Looks like IYM
  • AG33 - election of method @ issuance of contract and cant' be changed w/o written approval of ins commissioner

• same basic principles apply
• difference - PV appropriate future "valuation considerations" is subtracted from PV of each of the future benefits
• "valuation considerations" - portions of teh respective gross considerations applied under the contract
• not as easy to "analytically" determine where CARVM reserve will be, therefore lots of calcs

• since prems flexible, they aren't "req'd by the terms of such contract"
• reserved as SPDAs
  • if contract has no SC, guar fund accum rate > i_valn for n years after valn, CV @ last year i_guar > i_valn
  • Valn Actuary should still use judgement

• generally no problem under CARVM
• AG9 and AG9B define Immediate Annuity
  • 1st payment due not more than 13 mos from issue date
  • suceeding payments at least annually for at least 5 years
  • pattern of payments due in any contract year not > 115% of those in prior contract year
• can value annuity as settlement option or annuitized DA using immediate annuity rate from original contract issue or current rate
  • must be consistent
• AG9A and AG9B have special guidelines for structured settlements

• 80 amendments introduced annuity valn int rate categories
• SPIAs and annuity benefits w/ life cont arising from other annuities w/ cash settlement options and GICS w/ cash settlement options
• Other ANnuities
  • whether or not policy offers cash settlement options
  • issue year or change-in-fund basis
  • whether or not policy contains future int guarantees applicable to future considerations (future > 1 year off)
  • w/ cash settlement options - # years int guar in excess of long life rates (guarantee duration)
    • and w/o cash settlement option - # years from purchase date to 1st payment date
  • plan type
    • A) at any time the PO may w/d funds only
      • 1) w/ adjustment to reflect i or assets values changes since reciept of funds
      • 2) w/o adjustment, but in installments over 5+ years
      • 3) immediate life annuity
      • 4) no w/d permitted
    • B) Before expiriation of int rate guarantee, PO may w/d funds
      • 1) same as a1)
      • 2) same as a2)
      • 3) no w/d permitted
      • at end of int rate guar, funds may be w/d w/o such adjustment in single sum or installments < 5 years
    • C) before expiration of int rate guarantees, PO may w/d funds in single sum or installments < 5 years
      • 1) w/o adjustments to reflect i or asset value changes since reciept of funds
      • 2) subject only to fixes surrender charge stipulated in contract as % of fund
• AG33 - different benefits under SPDA may be valued assuming different plan types
  • defines guarantee duration as # years from contract issue to date of annuitization

• Variable products - policies whose cash values matched by assets held in sep account of the LIC
• CRVM adn CARVM are prospective methods
• variable products don't have future guarantees
• Variable Life Ins Model Reg - 1983 - w/ actuarial principles that recognize variable nature of benefits proivided and any mortality guarantees
• similar to VA Model Reg
• Reserve methodology dependent upon product type

• Flexible Premium Variable life aka VUL
• main diff between VUL and UL - accum fund - VUL - bears investment risk since tied to fund
• Hybrid Products - scheduled premium concept is used
• if VUL products fully front-end loaded, CV is generally deemed to be sufficient reserve
• if FY loads > renewal year loads by more than EA_CRVM, CV as reserve is questionable
• if back-end loaded, typically use UL Model Reg type reserve with one of following for i
  • if has fixed-acct option, long term guar rate in teh fixed acct
  • valuation rate less some (or all) of contractual asset-based charges
  • 4% (rate specified in tax law)
  • rate credited to policy loans
• SEC adn Model Reg require asses in Sep Acct >= acct value
• Stat Vx on back-end loaded can be < account val to reflect SC
• suplus in sep acct >= sum VUL EA credits taken
• Additional reserve req'd if product has GMDB

• Typically FEL
• DB adjusted to reflect performance in one of two ways
  • NY Life Design
    • DB = Orig Face * Actual CV / hypothetical tabular CV
    • hypothetical CV calced using AIR (assumed int rate)
    • GMDB = orig face
    • reserves = trad reserves fro policy if @ current DB, IA, dur
  • Equitable Design
    • net investemnt earning > AIR used to purchase PUA @ NSP using AIR
    • negative buys negative PUAs
    • if PUA balance < 0, negatives carried forward againt future PUAs, but DB never drops below initial face
    • reserve base as if traditional
    • PUAs like normal PUAs
    • additional reserves for GMDB risk

• Flexible Single Premium
  • marketed as single premium, but PO can make additional prem payments
  • reserved as if VUL
• Fixed Single Premium
  • GMDB w/ gross premiums based on AIR
  • can be of Equitable or NY Life method or may use UL-type mechanics to generate CVs
  • reserved identical to regular permanent contracts of same type
• Tax law changes in 1988 have virtually eliminated teh market for these

• FEL - CV is good and sufficient reserve (in general)
• BEL - subject to debate - same methods as proposed for VUL
• SA surplus s/b >= excess of acct value over reserves

• Variable Life Model Reg requires reserves if product has GMDB
• GMDB reserve carried on general acct
• different calcs for fixed premium and flexible premium VL contracts
  • flexible premium - GMDB only for grace period when funds insufficient to support deductions to maintain coverage infoce
• term cost of GMDB assuming immediate 1/3 drop in current value of SA assets followed by net investment return = i_valn

• GMDB typically DB never less than orig face
• V_GMDB(x) = max(OYT & AA Level reserve)
• OYT Reserve - term cost of GMDB covering 1 full year assuming immediate 1/3 drop inSA assets value followed by investment return = AIR
• AA Level Reserve = "residue" of prior years AA level reserve +/- current "payment"
  • can not be < 0
  • "residue" = prior year's AA level reserve increase @ i_valn - tabular mort for GMDB / tabular probability of survival
  • "payment" = (A_GMDB(x+t) - A_SADB(x+t) - residue)/adue(x+t:n|)
  • SADB = sep acct DB calced using actuary chosen i (but <= max valn rate)
• for VUL - GMDB = OYT reserves except measure over GMDB period instead of 1 year

• Method 1 - OYT cost of the shortfall w/ or w/o 1/3 drop
• Method 2 - allocate an annual contribution (% of acct value, vary by dur) to GMDB Vx
  • any DB in excess of basic reserves deducted from GMDB reserve fund

• may misc reserves quite small and tedious/difficult to calculate exactly
  • in practice - less precise techniques used, such as
    • single average age
    • single set of factors for range of policy forms
• Valn Actuary must be prepared to show that these approximations do not significantly overstate reserve liabs

• reserves in attidion to basic reserves w/ gross premiums < certain level
• US
  • prior to 1976 - SVL stated V_def(x) req'd if gross prem < valn net prem (if valn net prem used)
  • criticisms
    • reserve strengthening could cause basic policy reserve to increase. GP could be sufficient at old rate and not under lowered rate
    • having conservative reserve basis sometimes caused def reserves and wouldn't be req'd w/ more agressive reserves
    • V_def(x) not allowed as a tax reserve
  • 76 amendments removed specific references to V_def(x), but basic reserves req'd to be increased in certain instances
    • reserve is max(a,b)
    • a - Vx calculated according to method, mort table and int rate actually used for policy
    • b - Vx calculated by policy method, using min valn standards for mort, int and max(valn net prem, gross prem) each year
    • excess of b over a is referred to as V_def(x) everywhere except SVL
    • since part of Vx definition, gets tax credit
  • Def Reserves don't follow usual pattern of prem paying life reerves
    • generally have max value at issue and decrease w/ time
  • because of resulting surplus strain - try to design product w/o (or minimal) def Vx
• Practical Considerations of Def Reserves
  • GP is total annualized GP for policy, including modal loading and policy fee
  • premiums for benefit/riders not included, but deficiencies in base can be offset by sufficiencies in riders
  • because of these complications, usually calc these reserves via seriatim method
  • many co's continue to calc using the old method. Produces teh exact same reserve in typical case
• Def Reserves for Renewable Term Policies
  • old school - series of sep policies for reserve purposes - never V_def(x) for ART until mid-70s
  • late 70s - early 80s - lower ART rates, regulators concerned, state regs said to consider it an ongoing policy
  • 2 methods for looking at valn prems for ART
    • Unitary Method - considers entire stream of future gross prems & develops proportional set of valn net prems
    • Term Method - looks at each renewal period separately
  • Unitary Method fell into disfavor w/ regulators since ultra high prem @ old ages offset deficiencies at early ages
  • AG4 (1984) - term policies w/o CV - req'd add'l reserve if future guar prems < valn net prems as calced using a special basis in AG4
  • Valn Model Reg (1995) - Contract Segmentation Method
    • G(t) = GP(x+k+t) / GP(x+k+t-1)
    • R(t) = q(x+k+t) / q(x+k+t-1)
    • GP is guar gross prem w/o policy fee (if pol fee is level) - NY says uses current prem
    • q(x+t) = valn mort rate for def reserves
    • each time G(t) > R(t) a new segement is created +/-1% on R(t) to avoid new segments b/c of rounding
    • basic reserves calced for each segment, EA_CRVM only for first segment
    • Valn net prems a constant % of gross
      • ex. 10 yr renewable term - CRVM first seg, NL thereafter
    • Valn Model Reg - Vx = max(unitary, segmented) for each dur
      • n-year renewable term w/ non-deficient guar prems exempt & some AA YRT
    • Def reserves calculated as per 76 amendments using gross instead of net
      • 5 year safe harbor if 1st segment < 5 years, don't have to use gross, even if deficient
        • actuary must opine that reserves are sufficient
      • Valn Model Reg allows updated selection factors in calc of basic reserves
        • even lower selection factors OK for def reserves
• Canadian Practice for Renewable Term Policies
  • Valn Tech Paper #2
    • valued to end of benefit period, not renewal
    • excess of heaped @ renewal over normal renew comm may be treated as issue expense
    • how-to calc valn net prem if gross not level is described
    • lapse rates can spike @ renewals if prem increases
    • re-entry proportion (% of PO who will requalify for select @ rentry)
• Alternative Min Reserves for UL (AMR)
  • these are UL equiv to def reserves and covered in Chapter 4

• Usually calced using 1959 ADB tables
• calced using same methodology
• [t]V_ADB(x) = [1000*(M_ADB(x+t)-M_ADB(x+n)) - P_ADB(x)(N(x) - N(x+m)]/D(x+t)
• P_ADB(x) = [1000(M_ADB(x)-M_ADB(x+n)]/(N(x) - N(x+m))
• M_ADB(x) = sum(v*q_adb(x)*D(x))
• many approximations used, often w/ age and plan groupings

• SVL - reserve using Period 2 disablement rates of SOA 1952 disability study
• Active Life Reserves
  • what prem to waive - gross or net w/ or w/o wvr prem w/ or w/o other (ADB etc) prems
  • usually gross since commissions and what not still paid & ususally other benefits as well
  • many approximations used
  • reserves shoudl reflect prems (ex increasing if ART)
  • UL policies - two types
    • waiver of COI
    • waiver of planned premium
• Disabled Life Reserves
  • consists of 4 types of claims
    • approved, in course of settlement (ICOS), resisted, incurred but not reported (IBNR)
    • ICOS, resisted, IBNR considered policy claim liabilities
    • valuation of approved claims
      • disabled life annuities using tables mentioned in SVL and appropriate valn int rate
      • these factors applied to amount being waived
      • adue([x+0.5]+n-.5:t-.5|) where
        • x - insurance anniv prior to dis
        • n - policy year of dis
        • t - # years benefits run, from pol anniv in year of valn
      • normally use a seriatim valuation
• Disability and Death of Payor Benefits
  • typically waives prem to child's age 21 or 25
  • theoretical reserve complicated since 2 lives involved
  • if dis payor, both death and dis must be considered
  • essentially decreasing term so small or negative reserves expected
  • approximations normally used
  • usually ignore child's mortality
  • often hold 1/2 gross prem of payor benefit as reserve
  • reserve after death of payor is an annuity for remaining premiums
  • often mortality is ignored and annuity certain used

• term reserve for amt of ins = (m-1)/2m * P_modal <- net prem
• once common approximation
  • for each reserve basis, select a few major plans or key ages
    • calc S_tot (amt of ins) G_tot (gross AP) P_tot (net AP) and V_tot (base reserve)
    • Gbar = G_tot / S_tot Pbar = P_tot / S_tot (avg gross and net prem per $1m)
      • pick xbar where Pbar and Gbar are approx the same (find age that has these prems)
    • Vbar = V_tot / S_tot using xbar and Vbar, find approx tbar (dur)
    • using xbar, tbar calc [tbar]V'(xbar:n|) where n is orig prem pay period of paln (term reserve factor)
    • multiply term reserve factor by P_tot
  • after doing for each grouping
    • avg non-ded reserve factor is b/a
    • a = sum(P_tot) and b = sum(P_tot*[tbar]V'(xbar:n|)) across all plans
    • this factor applied to total net def prems for all plans w/in reserve basis
• Surrender Values in Excess of Reserves
  • excess of SV over Vx needs to be carried in 8G
  • based on seriatim, no offsetting overage w/ underages

• Valn Technique Paper #1 - Valn of Lapse-Supported Products
• established b/c Canadian Actuaries can recognize lapses in valn
• <maybe revisit this if applicable to 8I-U>

• Traditional
  • pays small db or becomes paid up @ first death
  • valued as single life after first death
• Frasier-Type
  • no change of status @ first death
  • valued independently of wheter a death death has occurred
• Reserves for Traditional Policies
  • if paid up @ first death A(x+t:y+t)bar - P*adue(x+t:y+t)
  • if pays x% @ first death and 100% at second death A(x+t:y+t)bar + xA(x+t:y+t) - P*adue(x+t:y+t)bar
  • after first death A(y_t) if paid up, A(y+t) - P*adue(y+t) otherwise
• Reserves for Frasier-Type Policies
  • l([x]+t:[y]+t)bar = l(xy)bar*([t]p(x) + [t]p(y) - [t]p(xy)
  • A([x]+t:[y]+t)bar - P*adue([x]+t:[y]+t)bar
  • joint equal age (JEA) often used to simplify calculation
  • AG20 - acceptable rules for JEA 80CSO for First-to-Die
    • many cos use these same rules for Last-to-Die

• Good and Sufficient - used to be OK to just do a GP valuatin
  • GP valuation used to cover following situations
    • stat Valn was deficient - did not consider w/d or expenses
    • experience mortality higher than stat valn standard
    • reserve strengtening needed due to investment yields not supporting valn i
• Now relies on Valn Actuary concept
  • CFT includes interaction between A/L under differernt int scenarios
  • impact of epidemics on co's resources
  • impact of mortality deterioration due to selective lapsation

• projection of cash flows in which specific timing of asset and liab cash flows is considered
• CFT generally recognizes the following factors
  • interrelationship between assumptions
  • competitors i & div rates
  • investment yields available in marketplace in general
  • company assumptions w/r to non-guar elements in different economic environments

• Future Economic Environments
  • must choose a set of future economic scenarios to test under
  • Handpicked Scenarios (aka Deterministic Approach)
    • 1990 SVL adn NY126
    • Advantages
      • teset is more comfortable w/ reviewing results since he constructed them
      • scenarios tend to be easy to describe (up/down, rapidly increaseing, etc)
    • Disadvantages
      • disagrement over probability of a scenario
      • cumbersome to generate a large # of hadnpicked scenarios
      • need a lot of scenarios for statistical credibility
      • tens to produce more favorable restults than expected statistically
  • Log-Normal Model
    • basic assumptions
      • ln(i(t+1)/i(t)) is Normal RV
      • mean (mu) = 0 and std dev (sigma) is measure of volatility to be expected
    • used to generate future s/t and l/t in rate
      • usually 90 day and 10 yr
      • other rates through interpolation or functional relationships
  • Transitional Probability Approach
    • define universe of yield curves
    • probability matrix - probabilities of one yield curve following another
    • start w/ current yield curve and run monte carlos to generate future yield curves
• Competitor Rate or Market Rate Assumption
  • important since many CFT funtional relationships key off relationship between credited int rates , mkt int rates and lapse rates
  • mkt rate assumptions often bases as function of current int rates and a moving avg of an int rate
• Nonguaranteed Elements Practices
  • Typical CFT strategies include
    • credit earned rate less investment margin
    • credit some function of market rate
    • hybrid approach
  • Lapse Rates
    • little experience w/r to interaction between lapse rates and credited rates on life and annuities
    • lapse assumption based on common sense argument - as other options become more attractive, more likely to surrender policy
    • things to consider
      • presence and level of SC
      • mktg techniques and loyalty of field force
      • prominence of i in mktg and maint of policy
      • duration from issue
      • type of products sold - SPDAs more int rate lapse sensitive than trad life
• Reinvestment Strategies
  • actuary and investemetn officer work together to understand/define how positive cash flows invested in future
    • ex. % of pos cash flows into each type of security or a blance of each type w/in total portfolio
  • need to define what mkt conditions might change this strategy
  • negative cash flows
    • sell assets
    • negative assets (borrowing between lines)
    • borrowing @ s/t rate

• Sensitivity Tests

• Statements of Financial Concepts (SFAC)
  • SFAC5 - Recognition & Measurement in Financial Statements
    • Guidance for expenses and losses in intended to recognize
      • consumption of benefit - expenses recognized when economic benefit is consumed
      • Loss or Lack of Benefit - losses recognized if it becomes evident taht prev recognized future benefits have been reduced
  • SFAC6 - Elements of Financial Statements
    • Expenses - outflows incurred in producing or other activities central to ongong operations
    • expenses represent actual or expected cash outflows that have or will occur as a result of ongoing central operations
  • implications - cost not an expense until it is recongnized in co's fin statement
    • example - DAC
    • amortization of the cost, not the original cost that becomes the expense
• Statements of Financial Accountnig Standards (SFAS)
  • SFAS60 - covers all contract except those reclassified by other standards
  • SFAS97 - covers most life and annuity products w/ account values
    • UL/VUL/most fixed def annuities and VA in teh accum stage
    • SFAS60 w/ prems payable < coverage period
  • SFAS91 - investment contracts defined in SFAS97
    • in general DAC for GICS, Funding Agreements & DAs w/ minimal SC
  • SFAS120 - Par Trad
• Terminology
  • DAC - amt of capitalized expenses remaining in balance sheet at any reporting date
    • aka Unamortized Aquisition Costs (UAC), Def Pol Acq Cost (DPAC), Unamort Expense Asset (UEA) and expense reserves